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.
Securitization is not currently a topic of debate in the litigation funding field. Litigation funding is, in and of itself, new (in the United States) and controversial and it is still in the process of claiming a place for itself in the financial markets. But a pre-cursor—selling investments in litigation to parties who are not parties to the original funding agreement—appears to be an existing practice. And, more important, a business model that involves developing and managing portfolios of assets seems like an invitation to securitize. This is so because securitization shifts the risk from the owners and managers of a portfolio to third parties. Because we predict securitization of legal claims will become an issue as the industry grows, develops and gains further acceptance we believe parties who are accepting funding are well-advised to address it in their contracts as we do in the Model Contract.
Securitization is a financing vehicle that can add tremendous liquidity to markets. To be sure, securitization is not per se bad, just as loans are not per se bad. But just as a given loan can be usurious or otherwise unconscionable, securitization does not work well for every asset class. We believe that litigation is one such asset class. The reasons, in a nutshell, are that litigation is an asset class susceptible to inflated security ratings; that securitization would shift financing incentives such that frivolous claims become attractive, a problem which also implicates the use of courts which are a public good; and that securitization would increase the pressure to commodify claims, diminishing the redress function of litigation. We currently see little that counterbalances those dangers. Further, the litigation finance market, while currently highly illiquid because it is new and small, does not appear to have a systemic liquidity problem that needs to be solved. Moreover, litigations typically resolve in three or so years, creating much less need to securitize as a way of reclaiming capital than with longer term investments such as mortgages.
The Dangers of Securitizing Financed Litigation
Securities backed by a portfolio of financed claims would be hard to rate appropriately given how difficult it is to quantify the risk of each claim. Such risk can only be approximately quantified by intensive due diligence of the claim. Given the ratings agencies’ failure to do effective due diligence on mortgages—which have underlying assets, houses, that are relatively very easy to value—it is hard to imagine that the agencies would do an effective job of vetting the litigations that would be offered as security. True, the ratings for mortgage backed securities appear to have been corrupt (based on the testimony to Congress and pending lawsuits), potentially weakening that experience as an analogy. However, the same factors that drove the apparent corruption of mortgage ratings have a potential of replicating themselves in the litigation finance market as it evolves. The key factors in the housing market were a) huge volume, b) a limited number of large issuers, and c) few ratings agencies. With mortgages, Wall Street appears to have used the leverage that comes from those factors to “ratings shop” and effectively “capture” the ratings agencies.
Regarding volume, the potential value of finance-eligible claims is thought to rival the housing market. Thus a securitization pipeline of claims could be just as large as the mortgage one. Regarding the limited number of originators, two factors suggest that is what the future holds for litigation finance. One, investment banking has gotten more, not less, highly concentrated in the wake of the 2008 financial crisis. Two, litigations are a specialized asset class and it is unlikely that many firms could credibly present themselves as properly vetting the assets. Finally, the only ratings agencies with clout remain Moody’s, S&P and Fitch. In sum, given the nature of the current marketplace and the nature of litigation as assets, we believe litigation backed-securities are at a high risk of being given inflated ratings. While this risk is relatively low if such securities are unusual, one-off type transactions, if such securities are successfully marketed it is hard to see why they would remain unusual.
If securitization of funded claims did become relatively common—and how common it becomes depends in part on whether such securities could be rated AAA (or at least investment grade)—funding frivolous claims seems virtually inevitable. Funders could originate-to-distribute, shifting risk nearly immediately from themselves to investors (the ‘moral hazard’ problem). This would dramatically reduce funders’ incentives to do proper due diligence. Our support for litigation finance is premised on the idea that the current incentives are to fund claims that appear to have merit because funders retain the risk and thus have strong due diligence incentives.
Courts as a public good
In the context of litigation, a further public interest is implicated: the proper use of courts, which are a public good. Since securitization is likely to incentivize the funding of non-meritorious claims, it is likely to flood the court system at the expense of the efficient adjudication of meritorious claims.
Commodification of legal claims
Finally, a common argument against litigation finance is that it facilitates the commodification of claims, which essentially means pressuring plaintiffs to focus on cash remedies to the exclusion of all others. This pressure increases when the funder’s true goal is to re-sell the claim to investors. We believe that the commodification dynamic can be limited in a given case through contract, say, by how the definition of “Award” is drafted, but an originate-to-distribute funder is unlikely to agree to terms that reduce commodification.
Again, securitization appears to offer the litigation finance market little upside to counter these risks to the funded party, the third party funders’ investors, and the public at large. One way to avoid the risks posed by securitization is to prohibit it in individual finance contracts.