The Need for and the potential role of Reputation Markets in Litigation Finance

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Although litigation finance parallels venture capital finance in many ways, one major marketplace difference is the (current) lack of reputation markets in the litigation finance world.  Reputation is valuable for funders seeking to differentiate themselves in a marketplace that is increasing in competitiveness and sophistication. It is important for plaintiffs and their lawyers as they seek to compare their financing options.  It is important for investors seeking to invest their funds in a litigation funding firm. Last but not least, strong reputation markets are a pre-condition for contracts to be able to (partially) replace regulation as they have in the VC market.

Reputation and clients

To see the importance of facilitating the development of a reputation market, consider what a potentially-funded plaintiff could learn if the litigation finance industry did develop one. First, funders would become known for their fairness—that is, ‘customer satisfaction’—as reflected in their contract terms and reported course of dealing. Second, funders would become known for their willingness (or lack thereof) to go to trial, and the corollary, how swiftly their cases tended to settle after receiving funding. Third, funders would become known for specializing e.g., in a subject matter, a litigation phase (appeals, international enforcements, etc.) and case size.  Fourth, funders would be known for the relative size of their settlements/judgments. Fifth, funders would become known for the level of control they seek when committing funding—are they active or passive funders—which would speed plaintiffs finding the type of funder they seek. Finally, funders could also be known for their pre-funding due diligence, such that a weak funder’s decision to fund is not a strong signal of the claim’s merits, but a strong funder’s investment is. Such signaling effect should yield quicker and therefore more efficient settlements.

Reputation can enhance efficiency for the benefit of both the clients and the funders in other ways. In addition to affecting how defendants assess the merits of a case based on a funder’s willingness to invest in it, defendants can also be expected to factor a funder’s reputation for going to trial generally; for the incentive of a specialized funder to go to trial as an investment in precedent; and for bargaining skill.  Defendants already do so with respect to the attorney or law firm representing their opponents. For any of that to happen, however, the defendant would need to know a) that the funding exists, b) who the funder is, and c) what that funder’s involvement  ‘means’–i.e. the funder’s reputation.  These effects of reputation are part of the non-monetary contribution funders make, discussed elsewhere. As we noted there, non-monetary contributions by financiers, in both VC and litigation funding, can be as or even more valuable than the capital provided.  Potentially, the more valuable a funder’s reputation the less capital they have to invest in any given case, freeing such capital up for additional investments.

Reputation, competition and regulation

The development of a reputation market would facilitate market entry and competition by new litigation finance firms, as they could use the information to position themselves and differentiate themselves within the litigation finance world. They would be able to offer better financial terms, boast of superior signaling effect or simply develop a new niche. All these will facilitate a better and more efficient litigation finance marketplace.

In addition, the existence of reputation markets enhances the credibility of an industry’s claim that (at least some) of its regulation can be self-regulation. If, e.g., publicly available examples of finance contracts that gain public acceptance become available the call for strict regulation may have less resonance.  In the VC literature, the existence of a strong reputational market is understood to be an economic force that binds formally but, more importantly, informally the VC funders reducing the need for regulation. (The intricate and complex equilibrium struck by the organizational and contractual structure of VC firms, and by extension potentially by litigation funding firms, and the role that the force of reputation plays in binding the two is discussed in M. Steinitz, The Litigation Funding Contract.  The important take-away for plaintiffs and their lawyers is that they may wish to due diligence the organizational structure of the funder and any fixed terms it requires to meet to raise successive funds (a bit more on that below).

The geographical proximity of VC firms both to one another and to the start-up companies they invest in (concentrated as those tend to be around Silicon Valley) is understood to be a factor that strengthens that reputation markets in VC. This feature of the VC market has no corollary in litigation finance (though it may be the case that the gatekeeping function that “Biglaw” is likely to have in the access to meritorious commercial claims may emerge is a functional equivalent.)

Reputation, funders’ fund-raising and conflicts of interest

Investors obviously seek the best-performing funds to invest in. In other words, they inquire into the reputation of the litigation funding firms that are soliciting their investment (or, in the case of start-ups, of the funding firms’ principals and the team they have assembled). In the VC market, where VC firms wish to raise successive funds, performance is assessed by requiring mandatory distributions of proceeds and through fixed terms that assure that at some point in a foreseeable future the performance of the VC fund is readily observable.

Interestingly, the need to develop reputation among investors via fixed terms creates a conflict between the funders and the plaintiffs because funders, especially new ones with no reputation, may wish to liquidate early to display their ability to produce profits across a portfolio whereas a plaintiff may wish to pursue its case past the point in time at which the funder needs to prove its abilities to its investors.

Conclusion

In short, the development of reputation markets would drive much greater contracting and market efficiency to this burgeoning industry. It will benefit both plaintiffs and ‘good’ funders who wish to distinguish themselves from ones who may engage in the unethical behavior industry critics fear. However, because reputation hinges on information and is tied to transparency the path to such development is not obvious given the current secrecy that shrouds the market, including its contracting practices.  The only way reputations can develop and reputational markets emerge, is if measures of performance become publicly available.  ‘Performance’ means different things to different constituencies in this context: investors in the funding firm will care about the bottom line whereas plaintiffs comparison-shopping will care about the fairness of the contracts they are offered and the likelihood that they will yield the highest possible return in their given case, rather than across a portfolio.

 

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