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There has been significant press surrounding litigation finance as of late. Particularly, litigation finance has been identified as causing a marked increase in lawsuits filed and increases in settlements in jury verdicts. To such an extent that a number of states have proposed and passed legislation to regulate it and require transparency. Hedge funds, institutional investors, foreign sovereign wealth funds, and wealthy individuals are participating in litigation finance investment in the face of a turbulent capital market.
In light of the uptick in popularity and potential impact to D&O insurance exposure, we thought it would be helpful to our readership to have a primer on the history and structure of funding lawsuits as an investment vehicle. Litigation finance (also known as litigation funding) is the practice of a third-party funder providing capital to a plaintiff, defendant, or law firm to finance legal proceedings, in exchange for a share of any financial recovery from the case.
First, a brief history and common law lesson. Having anyone other than the direct parties to the litigation profit from a suit was historically prohibited by English common law. This is the legal doctrine known as champerty. “Champerty” is a specific type of maintenance [the act of helping another prosecute or defend a lawsuit without having a legitimate interest in the case] where a person agrees to support a lawsuit in exchange for a share of the proceeds if the suit is successful. U.S. courts originally adopted champerty and maintenance doctrines, treating third-party funding of lawsuits as improper.
Australia was a pioneer in legalizing litigation funding, with courts recognizing its value in access to justice as early as the 1990s. The UK decriminalized maintenance and champerty and the passage of the Access to Justice Act 1999, which was intended to offer alternatives to the traditional means of litigation funding in the U.K., which at the time were conditional fee agreements. In the 20th century, US courts began narrowing the champerty doctrine’s application, with many relaxing or abolishing champerty restrictions. Some states still restrict litigation funding under common law champerty doctrines (e.g., New York), while others allow it more freely.
Litigation finance firms are commonly structured as LLCs (Limited Liability Companies) or limited partnerships (LPs), often organized with a fund structure similar to that of private equity. These entities are typically domiciled in jurisdictions like Delaware (U.S.), the Cayman Islands (offshore), or Luxembourg (EU) for fund formation. Similar to PE funds, there is the GP LLC (General Partner of Fund) that manages the Investment Fund, which is funded by Limited Partners (LPs).
The GP of the litigation fund can invest in a single claim or a portfolio of claims and receives a contractually agreed-upon portion of any monetary recovery. This can be structured as a multiple of the original investment or a percentage of gross recovery from the settlement or verdict. The litigation funder will usually receive the first dollar in until it is repaid, while the remainder of the proceeds will be divided between the claimant and attorneys pursuant to the funding agreement structure.
Litigation funders’ return on their investment depends on various factors, including the merits of the claim, the state of the law, the quality of the lawyers, the financing model (lump-sum or drip-fed), and the expected duration of the lawsuit (including time on appeal and time to collect a judgment). Lump sum means the entire committed capital by the GP is paid up front, typically at the beginning of the case or soon after the funding agreement is signed. Drip-fed means funds are released in stages, often linked to case milestones, budget needs, or performance conditions.
Funders perform due diligence on the plaintiff, the legal landscape, and the lawyers before committing to a case. Due diligence can take between 30 and 90 days, depending on the case, followed by negotiation of the deal terms. According to Bloomberg Law’s 2024 Litigation Finance Survey, litigation funding investors cited having a “return waterfall based on multiple of invested capital” as requisite deal term. A return waterfall is a tiered system that determines who gets paid, how much, and in what order as money comes in from a successful outcome (settlement, judgment, etc.). The multiple of invested capital (MOIC) refers to how many times the original investment a funder expects to be repaid before others (attorney and claimant) can share in the settlement or verdict proceeds.
This means litigation finance firms seek out and will pursue deals that have tiers of return of capital (ROC) with MOIC. For example, if a funder provides $5M to finance a lawsuit and the parties agree to a waterfall with tiers, if the case is settled for $20M, the funder gets back its ROC first ($5M), then the funder receives its preferred return MOIC (if 2x MOIC, $5M) and finally the remaining proceeds are split between the funder, plaintiff and/or law firm. Thus, the litigation finance firm is compensated first, reflecting its risk and can distribute the returns to LPs.
According to Bloomberg Law, 42 active funders held a combined $16.1 billion in assets under management. The average litigation finance deal size ticked up to $8 million last year up from $7.8 million in 2023. The average single-matter deal was $6.6 million, while portfolio deals averaged $16.5 million. Portfolios accounted for most deals—67%—holding steady from the previous year. Focusing on just the financial upside, litigation finance can appear to be an attractive investment vehicle. However, the market that is providing returns is the US justice system and, in some cases, insurance carriers covering the claims that are paying the fund multiples.
Given the above, D&O insurers should be aware that for litigation finance firms to maximize returns for LPs, attorneys involved in litigation funding are incentivized to make higher settlement demands and aggressively litigate claims that may be less meritorious. This may cause increased loss and expenses paid for securities class actions and other shareholder litigation when litigation funding is involved. Like it or not, litigation funding is an alternative asset that can directly profit from insurance proceeds.
Therefore, knowing which states have enacted third-party litigation funding disclosure requirements like Georgia, Louisiana, and Montana, and which state and federal courts have standing orders requiring transparency may be useful to underwriters. Also, ensuring that claims professionals are aware of the increasing utility of funding in various cases and pushing for discovery, requesting disclosure of third-party funding may be useful in strategizing a disposition strategy. Knowledge, in this case, is power.
The views expressed on this article are exclusively those of the author, and all of the content in this article has been created solely in the author’s individual capacity. This article is not affiliated with her company, colleagues, or clients. The information contained in this article is provided for informational purposes only, and should not be construed as legal advice on any subject matter.