The VC Analogy
One agenda of this project is to fully flesh out why venture capital is the closest analogy for litigation funding, rather than contingency fee arrangements or insurance. Professor Steinitz has already begun this work in prior publications, “The Litigation Finance Contract,” and “Whose Claim is This Anyway? Third Party Litigation Funding.”
While there are similarities between contingency fees and insurance, on the one hand, and litigation financing on the other and therefore the focus to date on analogizing the latter to the former is understandable, such analogies have their limitations, as illustrated below, and can, at times, mislead. As a result, our model draws on venture capital’s solutions to problems that litigation funders also face: extreme information barriers and asymmetries, extreme agency problems, and an extremely uncertain and risky asset. These solutions include representations and warranties; negative covenants, and most important, staged financing.
Venture capitalists and litigation funders have more in common than simply a similar risk landscape. Most of their investments fail while a handful is wildly successful. Success hinges, to a great degree, on the efforts of others – entrepreneurs and claimants, respectively. Both entrepreneurs and claimants have better, private information on the value of the asset (a start-up company and a legal claim, respectively) and may not have incentives to be fully forthcoming with that information. In both cases, such information asymmetry may actually increase during the life of the investment as more information about the asset is revealed. Beyond that, venture capitalists and litigation funders have similar (mid-length) investment timelines, they represent pools of investors’ capital and their profitability is measured across a portfolio of investments, not a single investment. These as well as other factors can misalign the incentives of funder and funded in both types of financing – venture and litigation – creating agency problems (conflicts of interest). Simultaneously, though, most venture capitalists and litigation funders have specialized expertise, reputations, connections and other valuable input that they can offer as non-cash contributions to the success of the investment. In fact, in both types of funding these non-cash contributions are paramount. (For a deeper look at the venture capital analogy, read our background essay on staged financing and “The Litigation Finance Contract.”)
Beyond the above economic characteristics of both types of financing, there are additional reasons to consider venture capitalism as a stronger analog for litigation finance than contingency fee lawyering or insurance. Contingency fee attorneys are first and foremost precisely that: attorneys qua attorneys. They have myriad ethical and legal constraints on their actions vis a vis their clients. Litigation funders are unconstrained by such rules and obligations. For example, they are not prohibited from investing on both sides of the same litigation nor are they prohibited from transferring sensitive or proprietary claimant information to adversaries and competitors. Funder’s objective is to maximize profits to the benefit of its investors which may, or may not, coincide with winning a case whereas attorneys owe a duty of loyalty to their clients. To analogize too closely to contingency fee arrangements is to oversimplify the complexities of the relationships involved. Nonetheless, on the issues such as unconscionability of fees/investment returns and control of the claim, cases and scholarship relating to contingency attorneys can be instructive, and we draw upon it as needed.
Insurers who fund and, at times conduct, the defense of their insured are also a limited analog, even though the relationship is commercial rather than attorney-client. First, the insurer finances a defense and counterclaim; most litigation finance is on the plaintiff side. Second, the insurer can subrogate the insured, making their interests united in a way not matched in litigation finance. Insurers and the insurance they provide do not, generally speaking, have access to justice implications. Importantly, insurance is a heavily regulated industry in contrast with litigation finance. For example, insurers have capitalization requirements that insure they can actually fulfill their obligations under an insurance policy. Despite these differences, just as with contingency fee attorneys, the insurer-insured relationship can provide some insight into litigation finance. As a baseline, litigation finance does function partially as after-the-event insurance in that it shifts risk to the financier (as insurance shifts risk to the insurer). Similarities can also be found particularly with regard to the attorney-client privilege, control or influence over choice of attorney and settlement decisions and with requiring the plaintiff’s cooperation.