Contracting for Funding in “Access to Justice Cases” versus “Corporate Finance Cases”

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Last week Professors Sebok and Wendel posted a comment on contract and tort good faith norms in litigation funding.  In it they expressed the view that they “do not think that the owner [of a claim, i.e. the plaintiff - MS] is in a position of vulnerability vis-a-vis the investor when negotiating the contract.” This gives us an opportunity to discuss one of our key takeaways from the debate that this website generated (some of which took place online but some of which has taken the form of private messages) and a key manner in which we will modify our model contract for final publication.

That insight is that the rhetoric surrounding funding commercial claims does not match a large part of the practice, at least in the U.S. Specifically, in the public debate about funding of commercial claims proponents of litigation funding invoke access to justice, but it appears that many of the financial products actually marketed at plaintiffs are designed to serve as methods of optimizing corporate finance.  As a result, reactions to contractual solutions to challenges that plaintiffs without access to justice face are met with responses that assume actual clients are empowered business entities. To be sure there are scenarios in which businesses (especially start-ups or small firms competing with large firms) and wealthy individuals require financing in order to access justice, but the proportion in the U.S. is likely much lower than in the pioneering litigation finance jurisdictions (Australia and the U.K.) because the contingency fee and class action mechanisms provide significant access to justice.  There is therefore a need to separate both the normative arguments and the contractual arrangements based one whether an engagement is motived by an inability to access justice but for third party funding or whether the funding is sought as a means of optimizing corporate finance.

If funding is provided as a means to access justice, i.e. if a plaintiff turns to a commercial funder because it has no other way to fund its claim, it is hard to envision how such a plaintiff is not “in a position of vulnerability vis-a-vis the investor when negotiating the contract.” In fact the access to justice plaintiff is susceptible to a classic kind of bargaining vulnerability called in the economic literature the hold-up problem.

We have discussed the hold-up problem elsewhere but to re-cap, hold-up is the term used to describe the disproportionate bargaining power that a funder has by virtue of its ability to shut down the company by ceasing funding. By extension, this is the problem a plaintiff who requires funding to access the court faces both at the outset, when approaching a funder, and throughout the life of the litigation because the termination of funding means they cannot pursue their claim. Research on staged funding by monopolist VC funds (as opposed to syndicates of funders) shows that such funding produces sub-optimal outcomes, meaning companies that would have succeeded if not held up fail.  Research also shows that the entrepreneur’s ownership share increases with the value of the project when later stages of the investment are syndicated.  We believe a similar impact could be expected on worthy claims.

Indeed, as we have discussed here, because of certain features of litigation such as the existence of opponents and of externally dictated deadlines, hold-up is exacerbated in the litigation funding context both at the outset and at each funding round. A plaintiff is also more disadvantaged even than an entrepreneur because the common solution to hold-up is syndication. Syndication exerts upward pressure on the value of the shares an entrepreneur is selling in the company. But, as we discussed, is harder to implement syndication in litigation funding.

None of these problems inhere when a plaintiff can afford to bring the claim but is using litigation funding  to optimize its accounting or to free up its own capital for other purposes such as running its operations, paying down debt or distributing dividends.  In those situations, the rest of the plaintiff’s capital structure ‘competes’ with the funder the way other funders would when syndicating. To use the terminology of negotiation theory, when a plaintiff is using litigation funding as a form of corporate finance it has a so-called BATNA—best alternative to a negotiated solution. A BANTA, as students of negotiation know, is one of the most powerful ways to enhance bargaining power.  The access to justice plaintiff, by definition, does not have a BANTA.

Consequently, we now believe that some of the protections the original draft model contract envisioned are appropriate for access to justice clients but are not necessary for corporate finance clients. These are, predominately, the Accelerated Investment, the Supplemental Investment and related termination provisions. Other protections may also be less important for the corporate finance client. For example, such a client may wish to waive protections against conflicts of interests or the buffer that is the Independent Counsel who otherwise advises, under the model, on decisions such as how to deal with conflicts of interest and whether to replace the litigation counsel.

Therefore, as we wrap up the Model Contract for publication (it is forthcoming in the Iowa Law Review) we intend to present two versions of it. One, which presumes an access to justice client and another, which assumes a corporate finance client.

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