Compliance & ethics in litigation finance

Since the beginning of the era of modern financial investment industry, when in 1864 J. Pierpont Morgan founded his investment company that was fated to become one of the world’s leaders in the field, investors have invariably sought new sources of income and thus of new profitable investments.

Unfailingly, after the major global financial meltdowns—and especially after the financial crisis of 2008-2009—the popularity of traditional assets such as stocks, bonds, and currencies decline and new alternative asset classes emerged. Today, alternative asset classes run the gamut from commodities, real estate, and private equity to art, vintage cars and wines, and forests and vineyards. Even loans can be considered assets as they are expected to be paid back, therefore, there is an expectation of profit. However, this concept was too primitive. We needed something more sophisticated, with higher returns on investment. Thus was created litigation funding—a form of crowdfunding in which investors chip in to the expected costs of pursuing a legal claim in return for a portion of the settlement or verdict that might result, not unlike the percentage an attorney takes from legal settlements as part of their own fee.

The concept of an outside party supporting a lawsuit is quite old (known as champerty in medieval Anglo-Saxon countries, where it was eventually prohibited due to an increase in rigged suits), it has been gaining ground in a different form over the last 10-15 years. Today, legal financing companies are springing up overnight and international conferences are held in the main financial hubs, such as one held in London on the 2nd of October 2017.

This article will focus on the practical functioning of litigation financing, especially when it comes to compliance and ethics.

Going Dutch

In their continuous pursuit of costs optimisation, companies have jumped on the opportunity to share their charges and have their litigation expenses financed by external investors, just as they leverage other business activities. Used both by plaintiffs and defendants, this technique, however, is no “Robin hood affair,” as Bloomberg puts it in a recent article on the steep rise of legal financing. Indeed, investors should consider a multitude of criteria in order to be sure not to pay over the odds and to infuse their monies in a lawsuit that is worth the candle. Nonetheless, that is not only about numbers: it is also a matter of human assessment and a human desire to support a good cause.

So how exactly does this work?

In the first place, we have a plaintiff—a claim owner or an accuser, and a defendant, natural persons or legal entities. In between—a batch of counsels, lawyers, solicitors, and…an investment fund. The latter, according to the Guide to Litigation Financing by Wellfleet Advisors, will “invest capital on behalf of investors.” Every aspect of a litigation process can be leveraged: from postal service to expertise expenses.

Every claim is assessed as a genuine venture. According to a 2014 article published in the Yale Law Journal, each aspect is scrutinised by legal funder’s teams: from “the claim’s likelihood of success” to “the estimated length of time to get through trial and final judgment (including the likelihood of appeal).”

Finally, not all suits are equally attractive: according to a 2010 RAND report—Alternative Litigation Financing in the United States: Issues, Knowns and Unknowns—antitrust, intellectual property, and contracts represent the top 3 of the financed lawsuits. A category gaining steam, however, are whistleblower cases, which are seen as having a solid return on investment; in case of success the repayment is guaranteed.

Show me the money

If the litigant financed by an investor wins the case, the latter will have his/her slice of the cake—the provided capital accompanied by a share of the winner’s financial recovery. If not, the funder loses, without recourse, the invested capital and gains nothing; the return on investment is thus contingent to the lawsuit’s outcome.

Some legal experts qualify legal financing as an investment, as an asset class, perhaps one even worth benchmarking. A legitimate question of a European Compliance officer then arises: what about the MiFID investor categorisation and classification of financial products by degree of complexity?

Article 25 of Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial isntruments and amending Directove 2002/92/EC and Directive 2011/61/EU—better known as MiFID II to the rest of the financial and compliance world—requires an assessment of suitability and appropriateness to be conducted before any offering of investment services to a client.

The more this area grows, the more likely it is to gain the attention of regulators, and the more certain it will require the talents of compliance officers to ensure that this new field stays within both the laws governing financial services, as well as the social expectations of how the legal system is supposed to work.

As litigation financing is not legally defined as a financial instrument, however, MiFID and even Market Abuse Regulation do not apply. Does this mean that we deal with a field beyond regulation? Absolutely not.

Litigation funding is largely unregulated, especially in Europe and the U.S. However, an independent body charged by the U.K. Ministry of Justice, through the Civil Justice Council, was created in 2011 in order to provide the legal finance industry with a supervisory authority that provides guidelines with regards to the business practices in the field. The Association of Legal Funders published a Code of Conduct for Litigation Funders for its members and acts as a governing body for the sector.

Most professional litigation funders bring on board solicitors and other professionals (e.g., chartered accountants) who will ordinarily be regulated by their professional bodies.

As far as ethical rules are concerned with regards to lawyers that provide advice on third-party funding, in England and Wales, the Solicitors Regulation Authority (“SRA”) has taken the lead and published a special guide that includes the SRA Principles and a Code of Conduct. This Code outlines some sort of a regulatory structure for lawyers.

Significant due diligence is also expected. Lawyers perform their KYC on the litigant and the funder conducts its own investigations. The key factors of a funder’s assessment of a case include: liability, causation and quantum, identity of the claimant, identity of the defendant, and reputation of professional advisers. This rigorous due diligence should identify any red flags prior to investment. Some legal funding firms, such as Burford Capital, conduct the entirety of its diligence and investment process in-house.

One may argue that the disclosure of certain confidential and sensitive insider information to a third party such as a funder may pose a challenge. However, the whole operation is secured: All communications between funders and lawyers are subject to the legal professional privilege that guarantees that no information will be disclosed without the consent of the interested party.

Linked to this concern, there is also an issue of conflicts of interest and of improper influence of a third party over strategic decisions and bias suits (intermeddling). Nevertheless, even if regulated mostly by soft law, contracts that funders sign contain specific provisions regarding these issues. Legal funders thus have no control over the litigation in itself.

Non-disclosure agreements are also more than common practice.

One interesting detail, however, has emerged while talking to legal eagles. “As lawyers, we have a client-attorney privilege. A confidentiality agreement that we cannot break,” say Cécile Terret and Constantin Achillas, solicitors at Bryan Cave Paris branch. “That is why we can sometimes prepare all the data to be transferred to a litigation finance company, but it is the responsibility of the client to effectively transfer it.”

Sui juris or sui generis?

Even in our age of Homo ethicus and Homo complianticus, we can be overtaken by events and thrown into turmoil. Think about the recent opprobrium involving international companies, alleged insider trading by the Deutsche Börse CEO and bitcoins being considered a means for money laundering. Few fields are un- or under-regulated today, but breaches still happen.

The abundance of NDAs, a certain secrecy of the legal financing market, absence of any official exchange or benchmark may hint at its opacity.

Litigation finance industry proves, however, that not all new developments pose a threat; on the contrary, it is a new way of working together, a joint effort to somehow achieve economies of scale.

Christopher Bogart, CEO of Burford Capital, confirms: “At the scale of commercial litigation at which Burford invests, the business of litigation finance depends on specialised expertise and human judgement, not algorithms, and indeed this insight and experience are highly valued by our clients and the firms with which we work.

Burford notes that per recent research, nearly a third (32 percent) of private practice and in-house lawyers in the U.S. say their organizations have used legal finance.

According to Burford, litigation finance still remains a small portion of the global legal economy and therefore has huge growth potential.

Anyway, it is clear that legal financing is a specific undertaking, an out-of-the-ordinary investment, and has a market to take on, especially in Europe. But the more this area grows, the more likely it is to gain the attention of regulators, and the more certain it will require the talents of compliance officers to ensure that this new field stays within both the laws governing financial services, as well as the social expectations of how the legal system is supposed to work.