Capping funder’s investment and contractual fiduciary duties: A response to Professors Sebok and Wendel

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Earlier this week, professors Sebok and Wendel posted a thought provoking post on contract and tort good faith norms in litigation funding. (The post is part of a more comprehensive analysis forthcoming in Anthony J. Sebok & W. Bradley Wendel, Characterizing the Parties’ Relationship in Litigation Investment: Contract and Tort Good Faith Norms, 66 Vand. L. Rev. ___ (2013)). Below are some of our thoughts and reactions to their post. Most of them are in the vein of how the Model Litigation Funding Contract (MLFC) avoids or minimizes concerns they raise regarding the relationship of the parties to litigation funding arrangement.

The key concern seems to be avoiding a situation in which a funder is forced to invest the full amount despite adverse developments in the litigation or even a revelation that the litigation is not meritorious. The risk arises, Professors Sebok and Wendel explain, because funders might be sued for exercising their right to refuse additional funding.

The extent of this risk can be minimized through contract language, and in fact, the draft MFLC provides a variety of safeguards against such an outcome. First, at the heart of the MLFC is a staged funding mechanism. At the outset, the parties agree on the Initial Claim Value, the Committed Capital and the Milestones—pre-agreed upon points in time in which information on claim value and plaintiff’s efforts and cooperation have been revealed. At each Milestone, the funder has an opportunity to invest more in the claim, or to stop funding. The right to stop funding is not simply implicit in the Milestone concept; the core termination without cause provision (6.1) states that the funder may avoid investing at a Milestone by serving notice of its intention without further explanation. (In addition, if the concepts of Accelerated and Supplemental Investments are used, the draft MLFC provides for other ways to terminate without cause, so the funder may avoid the effect of those provisions. However, termination under these circumstances entails a cost to the funder for reasons explained here).

Second, the MLFC contains a provision titled No Commitment of Additional Financing in which the plaintiff agrees that the funder has not undertaken to provide financing other than the investments set forth in the agreement and that the investment set forth in the agreement is subject to all of the conditions therein.

Third, these conditions include, inter alia, a representation that the plaintiff has provided funder with all material information; a warranty not to take any action that would materially and adversely affect the claim; a representation of completeness and accuracy of the information provided to the funder; and duties to cooperate with funder, to inform funder of claim progress and to notify funder of settlement offers and to give good faith consideration to funder’s analysis of the offer.

Fourth, the MLFC contains termination rights; both termination for cause, for breach of those of the aforementioned representations, warranties and covenants that the parties have agreed are Material Provisions or for Material Breach of Other Provisions, as well as for termination without cause as discussed above.

These should go a long way towards addressing a concern Sebok and Wendel raise, and which we share, of a scenario in which a judge mandates additional investment via a duty of good faith and fair dealing from a funder who has negotiated the right to exit the investment or any of the above rights. (For more on staged funding see here. For more on exit at milestones see here, here and here. For more on termination rights see herehere, and here.)

The MLFC acknowledges, however, that in cases where a plaintiff is seeking funding in order to facilitate access to justice rather than as a form of corporate finance—a key distinction in commercial (rather than consumer) funding which we’ll discuss in a future post—there is unequal bargaining power which leads to what economic literature branded as the “hold-up” problem. We believe that in access to justice cases, hold-up is a real concern and is likely to have in litigation funding analogous effects, detrimental to the plaintiff, as have been documented in the VC context regarding held-up entrepreneurs. The hold-up issue is exacerbated by the nature of litigation, in which the plaintiff has opponents instead of competitors; externally dictated deadlines; and faces a rigidly structured “marketplace” that is to a significant extent outside the plaintiff’s control. To address these issues for access-to-justice plaintiffs, the MLFC suggests using Accelerated and Supplemental Investments and the related termination provisions. (In the original draft of the model contract Accelerated and Supplemental Investments were a default. Following a post by Ken Linzer and Elisha Weiner we were persuaded to turn those into an alternate provision.)

Another concern raised by Sebok and Wendel is that that the plaintiff receiving the funding “might, after receiving a significant amount of funds to be used for litigation, divert or waste it.” The MLFC eschews the problem by requiring that the funds – received in tranches, never as a lump sum at the outset – be deposited in a Litigation Account, which is subject to an Escrow Agreement. The escrow agreement, in turn, ensures that the escrow agent shall use the funds in the Litigation Account only to pay the litigation Costs and its fee.

A final reflection relates to fiduciary duties. We suggest a plaintiff consider bargaining for a fiduciary relationship with funder where appropriate to deal with conflicts of interest that are similar to those that arise in the context of contingency lawyering. This means that if a plaintiff has bargained for such a contractual duty, then they can avail themselves of that contractual protection. This does not imply a tort claim if they did not bargain for it; quite the contrary, it implies that such a duty is either negotiated for or it does not exist (under current law). Moreover, given the other protections of a funder’s right to refuse further investment, including a fiduciary duty in a contract based on the MLFC should only give rise to causes of action where real improper conduct exists above and beyond a refusal to further fund a claim.

In sum, we share many of the concerns raised by Sebok and Wendel and believe we have provided in the MLFC mechanisms to avoid or minimize the risk of their occurrence.

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