The Secured Lender

Recent rulings and regulations addressing litigation finance are the best indicators that courts and States are finally catching up to a booming third-party litigation finance industry.

Complex commercial litigation typically take years to litigate and legal fees can grow very quickly and substantially, making it costly and, in some cases, economically difficult for a plaintiff to prosecute. Many such cases are taken by law firms on a contingency basis and paying the costs associated with such cases could impact the law firm’s ability to pay ordinary expenses, such as rent and salaries, during the years of litigation while waiting for what they hope will be a successful settlement or judgment. Litigation finance is a form of financing which has been used for many years to address capital needs of plaintiffs and law firms. In litigation finance, third-party investors, usually hedge funds or specialty finance companies, advance money, typically on a non-recourse basis, to plaintiffs or law firms to support their cash flow needs. When a settlement or judgment is reached in the related case, the third-party investor receives an agreed portion of the proceeds of the settlement or judgment as reimbursement of the advance plus an agreed return on its investment.

On the surface, this seems to fly in the face of the common law doctrine of champerty, which has been codified in most State laws. Essentially, champerty bars uninvolved and disinterested third parties from financially assisting or investing in a lawsuit in exchange for sharing in a recovery from such lawsuit. The rationale often cited is the fear that increased access to capital by plaintiffs will result in the filing of meritless or frivolous lawsuits. However, this rationale is weakened by the fact that non-recourse advances made by third-party investors are only repaid in the event of recoveries by the plaintiffs from the related lawsuits. Consequently, such investors are unlikely to fund meritless or frivolous litigation for fear that their advances will not be repaid.

Opponents of litigation financing also argue that a conflict of interest may arise because a litigation funder has objectives which may not coincide with the objectives of the plaintiff or law firms receiving the advances, raising ethical concerns. For example, a litigation funder may push for a quick settlement of the underlying litigation to reduce its risk, while the related plaintiff or law firm may believe the better strategy is to continue to pursue the litigation. While these ethics related arguments appear to have merit, the concerns are addressed by the inclusion of standard provisions in litigation funding agreements that prohibit the litigation funder from controlling or playing any part in the development of strategy for, participating in discussions with respect to the settlement of the case.

On the other hand, arguments in favor of third-party litigation finance are compelling. Aggrieved parties who do not have the resources to pursue claims against larger, more well-capitalized parties now have access to the funding they need to pursue their claims. Litigation finance has leveled the playing field for both sides of a litigation. Recent cases in New York and Delaware bear this out. In August 2015, the New York Supreme Court in Hamilton Capital VII v. Khorrami LLP, a law firm that borrowed funds from Hamilton Capital to pay expenses arising in connection with specific cases, challenged the enforceability of a litigation funding agreement. While champerty was not addressed, the court ruled in favor of Hamilton Capital and expressed its support of litigation financing as a matter of public policy because it “allows lawsuits to be decided on their merits and not based on which party has the deeper pockets.”

However, in October 2016, in Justinian Capital SPC v. WestLB AG, the New York Court of Appeals specifically addressed the New York champerty laws. The New York champerty laws restrict individuals and companies from purchasing or taking an assignment of notes or other securities “with the intent and for the purpose of bringing an action or proceeding thereon.” The statute further goes on to provide a safe harbor for transactions having an aggregate purchase price of at least $500,000. In Justinian, the court ruled that Justinian Capital’s purchase of securities solely for purpose of filing a lawsuit violated the New York champerty laws. While on the surface this ruling would appear to overrule the public policy position taken in the Hamilton Capital case and create problems for the litigation finance industry, the court based its ruling not on the repudiation of the litigation finance industry but on the fact that Justinian Capital did not actually pay for the securities and did not have a binding or bona fide obligation to pay the purchase price if the lawsuit was not successful. As such, it was not entitled to the benefit of the safe harbor. Thus, the message to litigation funders from Justinian Capital is that as long as a transaction is in excess of $500,000 and the purchaser has “skin in the game,” the transaction will fall within the safe harbor. It is ironic that the take away from a ruling that a transaction was champertous is that well-capitalized litigation funders (who make up the most substantial players in the third party litigation finance industry) who purchase securities and related claims and pay the related purchase price (if in excess of $500,000) do not need to worry about attacks on champerty grounds in New York.

In March 2016, in Charge Injection Technologies v. E.I. Dupont DeNemours & Company, the Delaware Supreme Court ruled that a thirty party funding agreement was not champertous. CIT brought suit against Dupont alleging that it wrongfully used and disclosed proprietary and confidential information belonging to CIT. As the litigation progressed and litigation costs mounted, CIT entered into a funding agreement agreeing to exchange a portion of the recovery from the case for funding to prosecute the case. Dupont challenged the agreement as champertous and the court opined that, because the litigation funder lacked any rights as to “the direction, control, settlement or other conduct relating to the litigation” and that CIT remained “the bona fide owners of the claims in litigation,” the funding agreement was not champertous. This ruling reinforces the principle that to avoid a claim of champerty, the funding agreement should include clear language that the litigation funder has no control over the litigation.

To be sure, not every jurisdiction has been riding the wave and there are still a few holdouts. In September 2016, in WFIC LLC v. Labarre, a recovery from a lawsuit was insufficient to pay all creditors of the plaintiff and a dispute arose over the priority of distribution of the recovery. In the course of sorting it out, the Pennsylvania appellate court ruled that “champerty remains a viable defense in Pennsylvania” and a fee agreement pursuant to which a litigation funder claimed an interest in the recovery was invalidated as champertous. The court then proceeded to set out the elements of champerty and the elements necessary to establish a prima facie case of champerty - “the party involved must be one who has no legitimate interest in the suit, the party must expend its own money to prosecute the suit and the party must be entitled by the bargain to share in the proceeds of the suit”.

Consumer litigation finance has also gained momentum towards full acceptance. Personal injury plaintiffs who need to pay personal expenses while waiting for their lawsuits to wind their way through the courts are able to obtain funds on a nonrecourse basis from consumer litigation funding companies. More and more states are enacting legislation to regulate the industry and protect consumers. However, by enacting legislation, they are at the same time acknowledging the legality and importance of the consumer litigation finance industry. More than a dozen states have enacted notice and disclosure requirements that must be provided by consumer litigation funding companies to plaintiffs at the time the funding is consummated. Some states require consumer litigation funding companies to obtain licenses or file applications prior to engaging in the consumer litigation finance business, and other have set rate caps or loan caps on the funds advanced. Further, some states have even extended the attorney client privilege to consumer litigation funding companies. Trade organizations, such as the American Legal Finance Association which represents the leading consumer litigation funding companies, have established Codes of Conduct, created standardized disclosure forms and serve as a resource to assist such companies with their compliance with applicable laws and ethical standards.

In summary, the adoption of rules by many states regulating litigation finance and the abolishment or narrowing by many courts of the champerty defense are all signs that states and courts around the country are recognizing that the financial wherewithal of a litigant should not be the determining factor in the outcome of a litigation and that the growth of the litigation finance industry promotes a fundamental principal of our justice system to allow disputes to be decided on their merits.

“Recent Rulings and Regulations Equals Recognition: Progress in the Litigation Finance Industry,” by Eliezer Helfgott and Scott Smith was published in The Secured Lender on June 9, 2017. To view this article online, please click here. Reprinted with permission.