CONFLICTS OF INTEREST
For general background on the analogy between venture capital and litigation funding please read this post. To review our assumptions please click here. This essay should be cited as Maya Steinitz and Abigail C. Field, “A Model Litigation Finance Contract” Iowa Law Review (forthcoming) available at www.litigationfinancecontract.com.
The focus of the essay is on potential conflicts of interests created by third party funding. Funding creates conflicts between funder and funded plaintiff, and can affect attorneys’ incentives and create new conflicts between the plaintiff and its attorney, or exacerbate existing ones. The essay highlights the key potential conflicts, drawing heavily upon Prof. Steinitz’s work and published analyses by the American Bar Association and the New York City Bar Association. Because our Model applies New York law, we relate the analysis to the New York Rules of Professional Conduct and New York State Bar Association opinions interpreting them.
Litigation finance arrangements are fraught with potential conflicts of interest for three main reasons. First, litigation funding creates a tripartite relationship that encompasses the plaintiff, its lawyer and the funder. Each one of these has interests that may diverge from those of one or both of the others. While the attorney is subject to ethical regulation that seeks to deal with such conflicts, to the benefit of the client, funders are under no such obligations. Funders’ only obligations stem from the funding contract and the contract law that governs it. Second, a funder’s fiduciary and contractual relationship to its investors sharpens and broadens its conflicts with the plaintiff. These investor-related conflicts are expanded further by the prospect of securitization of legal claims in the future. Third, funders are repeat players who manage a portfolio of cases and are seeking to maximize gains of the portfolio as a whole whereas plaintiffs are usually “one shotters,” interested only in the outcome of their case.
While some conflicts may persist throughout the litigation, two phases are particularly prone to conflict. The first is the negotiation of the funding agreement itself. The second is the decision of when (and by implication, for how much) to settle. The following paragraphs describe the main potential conflicts. We then discuss our suggested contractual solutions.
CONFLICTS OF INTEREST
Referrals and Repeat Play Between Funder and Attorney.
A funder may wish to offer an attorney a referral fee in order to steer clients its way. Or, funder and attorney, both repeat players in litigation, may have an ongoing relationship (e.g., referring to each other different matters at different times). Such relationships may distort an attorney’s incentives, leading her to refer a client to a funder that may not be best – cheapest, most competent, most liquid, etc. – for the client. Any repeat play (or even prospect of repeat play) between the funder and attorney may also create an incentive for the attorney to comply with funders’ wishes regarding case management rather than those of the client. An attorney may also wish to own or invest in a litigation finance firm, which would similarly align its interest with the funder rather than her client.
A New York attorney has a duty to exercise independent professional judgment and render candid advice. A New York attorney is under direct duty to maintain such independence despite being paid by a third party and she is prohibited from representing a client if “there is a significant risk that the lawyer’s professional judgment on behalf of a client will be adversely affected by the lawyer’s own financial, business, property or other personal interests.” (Rule 1.8(f)) Precisely how these rules apply in the context of litigation funding depends a little on who is asked: the New York State Bar Association or the New York City Bar Association. Opining in the mid-1990s, the New York State Bar stated that while lawyers can refer clients to litigation funders, they cannot receive referral fees or own part of the funding company but, in 2011, the New York City Bar treated as possibly open both whether attorneys can receive referral fees and whether they can own a funding company, but suggested the fees and practice might be barred.
More generally, financial relationships, interests and the potential conflicts involved mean the lawyer must fully inform the client and seek its consent, as well as recommend that the client seek independent counsel.
Billing Structures and Payment Schemes.
Often times, attorneys in a funded litigation work on a contingency basis. More specifically, they are often required by funders to have “skin in the game” – invest some of their own funds initially and/or accept a lower percentage of the pie. Their percentage ‘take’ may depend on whether the matter settled before trial, settled during a trial or went all the way to a verdict. Alternatively, funders require attorneys to accept a reduced hourly rate, at times with a promise of ‘uplift’ (bonus) for a successful outcome. Other billing arrangements are possible, each with their own set of conflicts. Payment may be on a rolling basis, at milestones or at the conclusion of the matter – each scenario further increasing the numbers of variations of possible conflicts.
Pressure to settle early or late. A well-known critique of contingency fees is that it incentivizes attorneys to settle early, that is – earlier than the client might wish to settle and for a relatively low settlement value. Litigation funders, like venture capitalists, have a similar interest in ‘early harvesting’ of their investments for reasons discussed elsewhere. Their returns from a case generally diminish over time. A litigation fund’s obligation to liquidate, under its limited partnership agreement, can drive a desire to settle at a point in time that is not optimal if the litigation prospects are evaluated on their own terms. Portfolio management dictates decision-making across the portfolio which may also point to an early exit from any given investment. Publicly funded funders may also have short-termism problems, being evaluated on quarterly performance basis. The converse conflict is also possible: a plaintiff who no longer bears litigation risks (as those have been transferred to the funder) may wish to protract a litigation beyond what is optimal or rational.
Finally, funders may on rare occasion wish to go to trial even when the plaintiff wants to settle, because the funders may wish to affect precedents when an outcome could favorably benefit other cases in its portfolio. When the facts and pre-trial rulings in a given case are particularly favorable, a funder could decide to push for trial even if the plaintiff would otherwise wish to settle. Conversely, with ‘bad’ facts and pre-trial rulings, a funder could wish to avoid a trial more strongly than usual, fearing a bad rule, even if the plaintiff wants to go to trial and could get a large verdict. While this ‘playing for rules’ conflict is probably very unusual—the chance of the good rule/bad rule would have to be high enough to outweigh the funder’s normal focus on maximizing profit in each case—the specialization of funders in particular areas of law and examples of such strategic behavior by insurance companies, entities that similarly run portfolios of cases, and the plaintiff’s bar makes the conflict plausible.
Incentives to underinvest. A closely related conflict is the fact that a funder, be it a third party financier or a contingency attorney, may wish to underinvest in a litigation, especially since such funders are weighing the cost and benefit of investing across a portfolio of cases whereas the plaintiff is concentrated in its one case. An additional investment necessary to promote the plaintiff’s chances may be even more profitable if invested in another litigation in the portfolio.
Monetary versus Non–monetary Payoffs.
Funders – both contingency lawyers and litigation financiers – are generally interested only in a monetary return for their investment while plaintiffs might value other remedies: injunctive relief, declaratory relief, a public apology, a change of an internal policy or a change in the law. Consequently, a funder might push a plaintiff to settle for money rather than for non-monetary relief. While probably less common, the reverse scenario may also occur: attorneys and funders may wish to set a precedent, as discussed above, or win a symbolic victory for reputational gains. New funders, in particular, might wish to establish reputation, e.g. to raise capital for successive funds, as has been documented in the VC context.
Attorneys’ incentives to exert or avoid pressuring a client include ethical obligations that render such pressure unethical. Settlement pressure conflicts of interest also implicate the rules that are aimed at insuring that an attorney exercises independent judgment, free from influence by financial considerations. The New York City Bar Association’s Opinion frames tensions surrounding settlement decisions in terms of “control” of the lawsuit and suggests these issues may be resolved purely by disclosure and client consent:
“While a client may agree to permit a financing company to direct the strategy or other aspects of a lawsuit, absent client consent, a lawyer may not permit the company to influence his or her professional judgment in determining the course or strategy of the litigation, including the decisions of whether to settle or the amount to accept in any settlement.” (2011 NYC Bar Opinion on Litigation Finance at Section E and FN 24)
However, not all authorities agree informed client consent is sufficient. The ABA draft opinion notes that even if giving settlement authority to the funder may be permissible as a matter of contract law and champerty, the resulting restriction on the lawyer’s independent judgment could be great enough that the lawyer could not ethically participate in the litigation.
But whereas attorneys are required to put their clients’ interest ahead of their own, funders are not currently operating under a similar regulatory regime. Moreover, we believe a financing company should receive as much control of the suit as it is willing to pay for, including control of settlement decisions. Beyond the ethical concerns raised by the current lawyer-regulation regime, however, we believe that giving full control of the litigation to the financing company, such as requiring the financing company’s consent to settle, creates a small, fact-dependent, but nonetheless real risk of champerty under New York law. The risk arises because in New York funding may be deemed champertous if a claim is transferred to the funder prior to the initiation of the suit, under certain circumstances. And some New York cases suggest that if the funder receives sufficient control then claim transfer has occurred. The risk is small and fact-dependent because mere transfer of a claim that is then sued on for profit is not inherently champertous under New York law; the desire to file suit must have motivated the transfer of the claim.
Portfolio Management and Fiduciary Duties
As discussed above, funders do not currently have fiduciary duties to plaintiffs, although they do have such obligations to their investors. While a fiduciary relationship between funder and plaintiff could be created if courts find that financiers (principals or staff lawyers) who are licensed attorneys are acting as plaintiffs’ attorneys when they invest in and manage lawsuits, this issue has not yet been brought before a New York (or other) court. Similarly a fiduciary relationship could be imposed if another regulatory body of law that imposes fiduciary duties (e.g., financial regulation) is held to apply, financiers do not have fiduciary obligation towards the plaintiffs whose claims they fund. Regardless of whether funders are ever fiduciaries of plaintiffs, they do have that relationship with their investors. In addition, as discussed elsewhere, portfolio management principles mean that efficiencies across the portfolio or, indeed, even across multiple funds may be achieved by sacrificing profits in any particular investment (in this context, any given litigation). This includes a potential desire to bundle and securitize the portfolios, a Pandora’s box also discussed elsewhere.
The lack of a fiduciary duty between funder and plaintiff coupled with a portfolio approach to minimizing risk means funders may invest in both sides of the same litigation. Absent affirmative disclosure by the funder, the plaintiff probably has no way of knowing that the funder is invested in both sides.
Another conflict between plaintiff and funder arises from the funder’s ability to work with the plaintiff’s competitors. Given funders’ access to plaintiffs’ sensitive information, funders can facilitate industrial espionage by selling or sharing the plaintiff’s sensitive information or intellectual property.
Our model contract addresses this cluster of conflicts in a few ways. First, we impose a number of representations on the funder. The funder represents that it has not paid a referral fee to the litigation attorney, that the litigation attorney does not own any part of the funder, and that any other financial relationships it has or has had with litigation counsel are fully disclosed on a schedule. The funder also represents it has not invested in any way adverse to the plaintiff, and that it is not bound by fund liquidation or other internal requirements to stop financing the claim after a few years.
Second, we have the plaintiff represent it received independent counsel about the terms of the agreement before entering it, and about the relationships, if any, between the funder and litigation counsel and the funder and any defendant. (The latter implies, of course, a recommendation that plaintiff seek independent counsel to negotiate the funding arrangement).
Third, we propose the funder acquire influence but not control over the settlement decision by requiring the plaintiff to give prior notice to the funder of settlement offers and to give good faith consideration to the funder’s analysis of the settlement offer. However the plaintiff retains control of the settlement decision. We strike this balance to avoid the potential ethical and champerty issues of ceding greater control to the funder, but nonetheless give the funder an opportunity to monitor, protect and maximize its investment.
Fourth we require strict confidentiality and limit information sharing to protect against industrial espionage facilitation. Fifth we protect the plaintiff’s interest in seeking non-monetary remedies by excluding them from the definition of the “award” that is shared with the funder.
Finally we impose a broad solution, namely, a fiduciary duty between the funder and the plaintiff.