Funded versus Funder Conflicts: Bad Faith Should Be Contract Breach, Not Tort Injury

We expect that eventually every state in the USA will accept litigation investment as fully and completely as it has been accepted in England and Australia.  Many questions will remain if this comes to pass, especially if the commercial litigation finance sector grows in size.  In this entry we will discuss our thoughts about how disputes between funders and the parties they fund will be handled by courts in the future.

Although there have been no reported cases (that we know of) in which a court has had to adjudicate a suit for damages between a funder and the party its has funded (whom we shall refer to as the owner, since they are the “owner” of the claim), it is only a matter of time before such cases make it into the courts.  To be clear, the kind of dispute we are in this entry discussing is not one that arises because the owner refuses to pay the funder after the successful completion of the litigation.  There have been cases such as these (although only, as far as we know, in the consumer sector).  The dispute we wish to consider would arise either after the failure of the litigation, or a resolution that was unsatisfying to either (or both) the funder or the owner.

Claims for injuries might arise from a variety of circumstances, and the injured party could be the investor or the owner.  An owner might, after receiving a significant amount of funds to be used for litigation, divert or waste it, thus damaging the value of the litigation to the funder.  Conversely, an investor, after having negotiated and received some degree of control over the litigation, might exercise that control in a way that favors their own interests over the owners.  Both of these are examples, albeit limited ones, of conflicts arising from what have been called “relational contracts,” i.e., contractual relationships in which the parties’ rights and duties are not definitively established at the outset, but evolve over time as circumstances change.

We have written an article examining the various legal responses that have arisen from cases in which a party to a relational contract has suffered an injury as a result (allegedly) of their counterparties performance. [1] In this article we review the reasons that have been offered for treating certain injuries arising from contractual relations under tort law.  The most significant category of these tort-like responses arise from third party liability insurance contracts, although there has been widespread acceptance of tort duties in the performance of first party insurance contracts and, to a much more limited degree, commercial lending contracts.  See, e.g., K.M.C. Co. v. Irving Trust Co. 757 F.2d 752 (6th Cir. 1985) (recognizing tortious breach of the implied obligation of good faith and fair dealing in banking contracts).  In many of these cases, courts appeal to the norm of good faith, but of course bad faith conduct does not necessarily give rise to a tort cause of action; it may instead be a breach of an implied term of the parties’ contract.  In the latter case, the challenge for courts is to distinguish between driving a hard bargain and opportunistic behavior.

To see how a litigation investment contract can be a relational contract, it is easiest to examine one kind of litigation finance contract, that is, one in which the investor and funder mutually commit to the possibility of subsequent investment in the litigation after the first tranche of funding.  This is kind of “sequencing” is a widely used device in the world of finance, from venture capital to commercial lending.[2]  Sequencing  provides the claimholder with the flexibility of seeking only the funding it needs at the outset (with the possibility of seeking more funding later) and it gives the funder the discretion to invest even more deeply in litigation if it is comfortable with the litigation as it unfolds.

The whole point of building sequencing into a litigation investment contract is to allow both parties to maintain a certain degree of flexibility.  The alternative, which would be to force parties to structure their investments as a one-time decision, would be to no one’s advantage, since it would raise the cost of investment for no good reason.  Still, it is well known that sequencing can result in one party gaining an advantage over another as time passes.  In the area of commercial lending, some courts have imposed a duty of good faith and fair dealing on a lender who unreasonably refuses to make subsequent investments in a contract that explicitly allows for such a refusal.  These cases have been criticized by scholars such as Daniel Fischel, who argue that the whole point of allowing a party to refuse to make an investment is to create a bonding mechanism that protects that party from the other’s failure in some respect to uphold its own obligations under the contract.

How should a court approach a claim by an owner that an investor “unreasonably” refused to make further investments in the litigation, or that the investor acting in bad faith, chose not to engage in another round of financing because it wanted to pressure the owner into accepting a settlement which was not in the best interest of the owner?  We reject the easy way out, which would be to borrow from the doctrines of bad faith in insurance law or the language of breach of fiduciary duty.  Our reasons, in brief, are the same as those courts that have rejected similar duties in the event of breaches between contract parties in most pure economic loss cases.  We do not think that the owner is in a position of vulnerability vis-a-vis the investor when negotiating the contract and we certainly do not think that the litigation finance contract bears any of the hallmarks of a true fiduciary relationship.  The language of good faith should not mislead courts into thinking that these cases must be handled under a tort or breach of fiduciary duty rubric.  As a matter of contract law, it is important for courts to differentiate between true optimistic behavior and seeking the benefit of a contract provision the parties had bargained for as a means of safeguarding against the type of risk that subsequently occurred.

In our article we end at the point of predicting that contract law will govern these disputes, but we are willing to accept that there may some limits to contract.  For example, the Association of Litigation Funders of England and Wales has proposed a set of limited obligations for funders who are in a position to adversely affect a claimholder’s litigation by exercising a contract right not to fund any further.  The Code of Conduct for Litigation Funders provides that a funder may refuse to provide further funding if it (i) reasonably ceases to be satisfied about the merits of the dispute; (ii) reasonably believes that the dispute is no longer commercially viable; or (iii) reasonably believes that there has been a material breach of the contract.  The Code of Conduct clearly imagines a very narrow range of obligations actions that cannot be waived ex ante by contract, much like there are certain obligations that accountants and lawyers may not escape even with the consent of their clients.   As to those duties which the parties may vary by agreement, it is significant that the Code of Conduct contemplates the bonding function of refusals to provide further funding if the funder is no longer satisfied that the dispute is meritorious.  This allows the funder to protect itself against the risk created by the asymmetry of information regarding the merits of the dispute.

If a court in the United States were to be confronted with a complaint by a claimholder that a funder, by withdrawing from the case, is violating the duty of good faith and fair dealing, it most likely would limit the application of the doctrine of bad faith to circumstances that fall outside of the three set out in the Code of Conduct for Litigation Funders.  This is a very narrow range indeed, but it is worth recognizing that it may become a foothold for a contentious and unruly set of extra-contractual duties between parties in litigation investment.

[1]  Anthony J. Sebok & W. Bradley Wendel, Characterizing the Parties’ Relationship in Litigation Investment:  Contract and Tort Good Faith Norms, 66 Vand. L. Rev. ___ (2013) (forthcoming).

[2]  Maya Steinitz, The Litigation Finance Contract, 54 Wm. & Mary L. Rev. 455 (2012).

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