If you’ve been to a casino, you have observed the phenomenon known as the “house money effect.” Simply stated: when people receive an economic windfall, they engage in risky behavior with it. Those who win big don’t react by asking their friends for advice on AAA-rated municipal bonds; they are more likely to use their newfound chips to make larger and riskier bets.
Unfortunately, while the house money effect works for casinos, it represents a threat to the business of litigation finance. At the casino, it aligns the interests of the winning player (who makes increasingly irrational wagers) and the house (which wants players to do just that, eventually “giving back” their winnings). In litigation finance, however, it threatens to divide litigants and funders, which want their counterparties to make rational decisions.
This first installment of our two- part Insights series explains why litigation funding can feel like house money (though it is not), the risks that presents, and how we correct for it in funding agreements.
Litigation Finance as House Money
Although litigation funders don’t practice law, compliance with rules of professional ethics is, of course, a primary concern. Some of those rules are grounded in common law, and three in particular constrain litigation finance providers. The first, champerty, prohibits third parties from taking an interest in a lawsuit. The second, maintenance, prohibits meddling by a third party to encourage a lawsuit. The third, barratry, prohibits parties from inciting vexatious or harassing lawsuits.
These principles represent overlapping ways of forbidding parties from “buying” lawsuits. This issue is of particular importance as regulators sometimes wrongly confuse the involvement of a litigation funder in a matter with control over that matter.
For example, a federal judge recently quizzed attorneys in the Marriott data breach case about whether they had funding—ostensibly to guard against an outside party “controlling” the matter. This is a red herring as the common law doctrines described above bar litigation funders from controlling lawsuits. Instead, we provide passive capital for litigants and counsel to use as they see fit.
Also of relevance are critical differences between traditional loan-making and litigation finance, including that in the event of failure, litigation financiers have no recourse to their client’s collateral. We are simply out of pocket. Instead of issuing loans (with interest to account for the risk), our contracts are structured as investments.
Ultimately, then, litigation finance contracts have two fundamental characteristics: the funder has no control over the lawsuit itself, and no recourse in the event of a loss. Litigants perceive an economic gain with no restriction on how to spend it and no negative consequence for losing it.
The financing, in other words, might feel a lot like house money, even though it isn’t.
Risks of Misalignment
Being scrupulous about adhering to the law places us in a strong position ethically, but a potentially scary one business wise. With no control over a plaintiff’s decisions, we can’t be sure they will act wisely with our funds. The house money effect suggests they won’t.
Consider a plaintiff who holds a $50 million settlement offer and a 1% chance of winning $500 million at trial. With litigation funding in place, litigants may be tempted to go for the irrational moonshot. And though good lawyers act ethically on behalf of clients, their economic incentives (driven by the billable hour) are sometimes misaligned with the goal of an early settlement.
If there were no solution to this, litigation finance firms would not be in business. Our industry has found logical and creative ways, however, to structure contracts that encourage all parties to make rational decisions.
For the sake of discussion, let’s use the simple example of an agreement with a single plaintiff to fund a single lawsuit. Such agreements generally provide that for any money flowing to the plaintiff from the litigation, the funder receives its money back (say, $10 million), plus the greater of some multiple (say, three times its funding, or $30 million) or a percentage of the total recovery (typically, 15% to 40%).
The tools that litigation financiers employ to align the interests of the parties include four common provisions.
- Tranches: Many contracts divide funding commitments into tranches—say, four tranches of $2.5 million for the purpose of our example. These tranches are “incepted” over the course of a lawsuit. In calculating the multiple owed back to the funder, the litigant pays a multiple only on the amount that has been incepted, rather than on the full funding commitment. Tranching alleviates a disincentive to early settlement that plaintiffs might otherwise feel.
- Escalating percentages: When funding has been tranched, many contracts assign escalating percentages owed to the funder for each tranche (say, 15%, 20%, 25% and 35%). These escalating percentages force parties to seriously consider earlier settlements and reduce the incentive to chase large-but-unlikely recoveries.
- Success components: We do not impose obligations on lawyers, including any obligation to discount rates or have “skin in the game.” To counterbalance a financial incentive which, in theory, could inhibit resolution, however, it is not uncommon for counsel’s compensation to include a success component that rewards them for early settlements.
- Partial contingency fees: To further align law firms’ interests with their clients’ and our own, we are open to partial contingency arrangements that give them upside for their recovery in the case, in exchange for discounted fees.
These devices go a long way toward harmonizing the interests of the parties in litigation finance arrangements. Collectively, they leave a strong possibility that all of them will leave the courtroom satisfied, calling it an early night when that is the smartest play.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Will Weisman is a New York-based senior investment officer at Therium Capital Management, a leading global provider of litigation, arbitration, and specialty legal finance.