Third-party litigation funding.

Abrams, David S.

Imagine a world where, in addition to investing in shares of corporations or trading oil futures, markets existed that allowed for the exchange of litigation shares. In this world, an individual with a legal claim would benefit by obtaining funding for the claim and reduce the risk from an adverse verdict. Investors would be able to diversify through portfolios of litigation shares spread across a variety of locales and legal doctrines. They might particularly focus investment in areas where the law is most uncertain, which could otherwise deter risk-averse plaintiffs.

Would such a world result in the encouragement of frivolous suits, excess litigation, and unethical attorney behavior? Until now there has been virtually no empirical research to answer those basic questions. This should come as no great surprise, as pure litigation trading markets as described above still do not exist. But recent developments in legal systems allow us to begin addressing these questions for the first time.

In a new working paper that I've co-authored with Duke University law and economics professor Daniel L. Chen, we make an initial investigation into the way third-party funding has functioned in Australia. We use data from the largest Australian litigation funder, the Australian courts, and citation information to begin to understand how third-party funding can affect the legal environment.

Developments| Several recent legal changes in different countries have moved our world closer to the one described above. The 2006 Fostif decision by the Australian Supreme Court legalized third-party litigation funding in that country. Australia also became the first in the world to have a publicly traded law firm. Just last month a new law went into effect in England that will allow non-lawyers to be part-owners of law firms for the first time. In the United States there has been tremendous growth in the past several years in the fledgling alternative litigation finance (ALF) industry and discussions about prospective legal reforms that could promote it.

In the United States, as in countries with common-law legal systems, the doctrines of maintenance and champerty have long prohibited outside financing of litigation. Those doctrines, with medieval origin, prohibit entities without interest in a legal proceeding to be able to share in its proceeds. The rationale for the prohibition is sensible: one might worry that justice could be perverted by wealthy outsiders bribing lawyers and plaintiffs to bring false claims. But in an era where defendants may have substantial resources themselves or have backing from well-financed insurers, there is concern that the expense of litigation may deter the pursuit of worthy claims.

The type of ALF that I investigate is third-party litigation funding, where an entity unrelated to the parties or attorneys provides funding to the plaintiff in return for some share of the eventual settlement or jury award. Deals are usually structured so that the plaintiff maintains at least a third of the settlement (and usually over 50 percent) in order to ensure that the interests of the funder and plaintiff are aligned. This way, the plaintiff still has strong incentive to produce evidence, assist attorneys in the preparation of the case, and provide testimony.

One of the great promises of ALF is that it may provide a mechanism for financing legitimate claims that would not otherwise be possible. In this way, third-party funding could work in favor of the pursuit of justice. For example, poor or credit-constrained plaintiffs may have worthy claims, but lack the funding to pursue them. A third-party funder could provide the resources necessary to allow these cases to proceed. Even entities that do not lack funds may be unwilling to pursue potentially valuable claims if they are risk-averse. A risk-neutral funder could vastly reduce the uncertainty in the outcome by providing a floor for the settlement and thus making it worthwhile to pursue the claim. Other contexts where third-party funding could be of benefit include ones of uninformed potential plaintiffs and cases with large coordination costs.

Empirical analysis| Would all this new litigation made possible through third-party funding inundate the courts? This is one of the questions that Chen and I investigate empirically, but there are reasons to believe that this may not be the case in the long run. Initially, one may expect the amount of litigation to increase. But after a period of adjustment, litigants will adjust to the new level of funding and any changes in likelihood of victory, and thus elect to settle in order to avoid court costs. Indeed, the new level of litigation in the courts could actually be lower in the long run.

One of the major potential benefits of litigation funding is that it is likely to specifically target the most uncertain and least settled areas of the law. Because these are the types of cases with greatest uncertainty, they are the ones least likely to be pursued by risk-averse plaintiffs. A risk-neutral litigation funder could expect to make the greatest returns in these types of cases and thus would fund them at a higher rate. This could lead to earlier clarification of the law, which in the long run will have substantial benefits. Clarity of the law leads to greater certainty in long-term decisions, which benefits all (perhaps excluding litigation specialists). This is one of the reasons why litigation funding counter-intuitively could actually lower the burden on courts while funding cases of greatest legal significance. These are two of the predictions Chen and I examine empirically.

Australia has been the most active country in the world in experimenting with ALF. In 2006, with the Fostif decision, the Australian Supreme Court clarified the legality of third-party litigation funding, which had already been growing for several years. I obtained data from the litigation funding firm IMF Australia (no relation to the International Monetary Fund), which is the largest third-party funder in the country, with over 50 percent of the market. Combining those data with data on Australian court processing statistics and case citation information allowed me to investigate some of the empirical predictions relating to litigation funding.

IMF Australia has funded 113 cases from 2001 through 2010, with a total claim value of over $1.5 billion (Australian). They are selective in choosing cases, with only about one in seven receiving funding. The average duration of a case from funding to resolution is about 2.3 years.

If one could design the perfect experiment to investigate the impact of third-party funding, it would legalize third-party funding in one state while maintaining the prohibition on it in another, otherwise-identical state. A number of economic studies use actual law changes to approximate this idealized experiment. One could then look at settlement rates, amounts, court processing times, and other outcomes.

In the Australian litigation context, the analysis is trickier, as oftentimes there was little actual funding in states immediately after a law change. Additionally, settlement data are unavailable because settlements are not required to be reported. Short of the ideal experiment, we use the closest data that are available: we use IMF spending levels as a proxy for the openness of an Australian state to litigation funding and examine changes in court case processing in response.

Chen and I find a correlation between the spending level of IMF in an Australian state in a given year and net expenditures by the state court system. There is also a negative correlation between IMF expenditures and both the backlog of cases and the number of cases resolved in a year. Taken together, this is suggestive of an association between third-party funding and slower courts. Due to data limitations, this finding must be seen as tentative. It may potentially be explained by variables that were not controlled for or it may be a short-term impact.

The other main prediction about litigation funding that one could test has to do with the significance of cases that are funded. One measure of the importance of cases is the number of citations they receive. The IMF data include information on all of the matters the firm considered, whether it ended up funding a case or not. In order to determine whether funding targets important cases, I compared the number of citations received by those published cases that received funding with those that did not. While the total number of cases with data is small, the results are striking. Funded cases receive over twice as many citations on average (11.0) than those that did not receive funding (4.6). This indicates that at least this particular third-party funder is funding cases that have greater legal significance than average.

So what can we make from these findings and how might they translate to the American context? One major difference is that contingency fees are legal in the United States and they provide some of the same benefits that third-party funding can. But contingency fees are not nearly as flexible. The source of funding is limited to the client's attorney, who himself may be risk averse or limited in how much work he is willing to perform without guaranteed pay. Contingency fees also tend to be for a relatively small fraction of the claim and may generally only be used for out-of-pocket expenses rather than a flat sum.

Third-party litigation funding would still likely have a meaningful effect on litigation in the United States. In addition, as other countries, particularly the United Kingdom, loosen their limitations on funding sources for law firms, American law firms may be hard-pressed to compete. For now, it appears that third-party litigation funding in Australia may be contributing somewhat to slower case processing, while focusing resources on more important cases. This may be a tradeoff worth experimenting with in the United States.

DAVID S. ABRAMS is assistant professor of law, business, and public policy at the Wharton School, University of Pennsylvania and Penn Law School.

Interested readers can find the working paper upon which this article is based at: www.law.upenn.edu/faculty/dabrams.