Recently, litigation finance companies and arrangements have become more commonplace in both the United States and abroad. Typically, a litigation finance company will give a plaintiff who otherwise might not be able to afford a lawsuit the funds needed to cover legal expenses. Loans are non-recourse; if the plaintiff loses the lawsuit, the loan is forgiven. Interest rates on such loans are accordingly well in excess of typical market rates, but the arrangements may be beneficial to plaintiffs who do not have enough cash on hand to finance a lawsuit and who either cannot obtain funds through traditional loan sources or do not want to risk the possibility of facing a large debt if the lawsuit fails.

The social welfare case for litigation finance is simple. Such financing enables liquidity-constrained plaintiffs to bring more cases and to prosecute cases more effectively. Increased funding for litigation should thus reduce legal error and help achieve the legal system’s goals, including both compensation and deterrence of negligent or wrongful acts. Litigation finance, however, at times might be used to fund nonmeritorious cases. It might seem that plaintiffs have no incentives to bring cases that would likely lose. But a plaintiff might have some probability of prevailing on even a nonmeritorious claim, and the possibility of legal error thus suggests a need to balance the benefits of legal finance (reduction in false negatives, where meritorious claims are lost because of lack of financing) with its costs (increase in false positives, where nonmeritorious claims prevail or receive a nuisance settlement).

We believe that agency problems in the lawyer-client relationship act as an important determinant to what types of claims are litigated and the allocation of awards among the client and lawyer. This paper posits that third-party financing of litigation could be a potent mechanism to alleviate agency problems in the lawyer-client relationship. Third-party financing will both align incentives between the attorney and the client and provide a strong signal of claim value to litigants. As a result, third-party financing will increase the number of strong claims brought by parties and could decrease the number of weak claims. Therefore, the social value of litigation will increase with ambiguous effects on the volume of litigation. However, even if the volume of litigation increases, third-party financing may lower transactions costs in litigation through the creation of sophisticated financial intermediaries who act as repeat players.

The common law has long forbidden third party investment in lawsuits based on “champerty” and related doctrines. More recently, these restrictions have been relaxed, although they may not have been entirely eliminated in the U.S. While it might appear efficient to allow such investment, in fact it is not. The effect of relaxing restrictions will be to increase litigation.

 

When there are benefits of litigation these are deterrence of harmful activities. However, the U.S. already goes much farther than any other country in allowing class actions and other group based litigation, and so any benefits of increased litigation are likely to be small or nonexistent.

 

There are two external costs from increasing litigation. First, the plaintiff must pay his own fees, but it also imposes costs – sometimes quite significant costs – on defendants when a lawsuit is filed. In many cases, the costs imposed on defendants are greater than costs borne by plaintiffs, especially when plaintiffs are individuals or class members and defendants are business firms.

 

Second, the type of lawsuits that would likely result from increased third party investment would probably move the legal system away from efficiency. Overall increasing third party financing of litigation is likely to be harmful.