Lawsuit investment and the limits of innovation

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As you probably know by now, I’m a big fan of innovation in the law. But there’s good innovation and there’s bad innovation, and what’s emerging in the litigation field in the US and the UK looks to me like it belongs in the latter category.

LegalWeek reports that UK hedge funds are lining up to provide funding for lawsuits. This idea in itself isn’t breaking news: several US companies, often backed by massive hedge funds, already provide financing for plaintiffs in personal injury suits — and arguably, contingency fee arrangements in class actions accomplish the same end, providing funding in return for a piece of the expected damages award. Hedge fund investments in plaintiffs’ lawsuits has recently spread to the UK. But this newest British development contains a twist: the investors are looking to finance the defendant.

Here’s how LegalWeek‘s Editor’s Blog explains it:

The investor is likely to be a hedge fund or special situations fund looking to make high-risk investments. The investor gets a fee or premium and effectively offers to fund a substantial chunk of the defendants’ liability. The attraction for defendants is hedging and managing their exposure, despite higher upfront costs. And by introducing an outside investor that will look at a legal opinion to gauge the merits and risks of the claim, a company can effectively put a ‘market price’ on their litigation risk.

The concept of a market in plaintiffs’ lawsuits has its supporters, who contend that the benefits include creating a more level playing field between plaintiffs and defendants and bringing market-driven risk assessments to evaluate lawsuits’ chance of success. Opponents cite concerns about champerty and maintenance, though it seems to me these prohibitions have not been pursued enthusiastically by governing bodies and have lost some of their force over time (lawsuit investors argue that they’re not instigating lawsuits, which is forbidden, but financing suits already underway, which seems a distinction bordering on the specious).

There are access-to-justice arguments in favour of allowing plaintiffs to seek financial backing to bring a claim and sharing the rewards with those who do so, and reasonable people can differ on this. But when defendants start looking for investors as well, I start getting worried.

I understand the attraction, and even some of the merit, in valuing and sharing the risk of defending a lawsuit. But if this takes off, then we’ll soon have lawsuits where neither the plaintiff nor the defendant hold controlling financial interests in an action that bears their names. What we’ll have is duelling hedge funds paying lawyers to play out an investment strategy in court for which they’ve placed bets on opposing positions. The courtroom would essentially be a legal commodities exchange, except with human judges replacing impersonal market forces. I think we can safely use the word “perversion” to describe the effect of this development on the justice system.

Commenters on a 2006 University of Chicago Law Blog posting on this subject raise other concerns. First of all, there’s the question of “subprime lawsuits”:

I suspect that the kinds of lawsuits for which an investment market will develop will be “sub-prime,” so to speak. The potential damages will be significantly smaller, the quality of lawyering (on both sides, given the stakes) will be diminished, and the risk of strike suits will be greater. Just as some law firms take large numbers of low-grade contingency fee cases to operate “on volume” — a few good ones will pay for the dozens of meritless ones, so too will this investment market. Investors in lawsuits will likely not evaluate particular cases on the merits, but look at a series of variables (e.g., lawyers’ win rates, judge’s leanings, awards in particular jurisdictions, etc.) to calculate the odds that their “portfolio” of lawsuits is more profitable than not.

Then there’s the issue of insider trading:

In all these information markets one wonders about inside information. Optimistically, market participants will judge when prices are moving because of insiders’ attempted manipulation. But a little regulation here and there might be expected (no trading in your own claim, for example).

And, most forcefully for me, there’s the argument that it’s just plain wrong to convert tort law, which is meant to be a vehicle for corrective justice, into just another financial portfolio entry:

Litigation is a form of social conflict, albeit a reasonably peaceable form, though those who have been sued have reason to feel differently about it. Rules requiring parties to fund their own claims rest on a policy in favor of social peace. Case law under such a view is assumed to be exemplary, not pervasive; legal norms should be largely self-enforcing, a view summarized in Grant Gilmore’s famous declaration “In hell there will be nothing but law, and due process will be meticulously observed.”

Quite possibly, the liquidity freeze that’s causing seizures throughout the international financial system will dampen hedge funds’ enthusiasm for throwing money at the instigators and defenders of lawsuits. But it’s just as likely that the elimination of other investment routes will make lawsuit venture capital more enticing: these funds have a ton of money and they need to put it somewhere. The enthusiasm with which major UK law firms have embraced the idea of defendant lawsuit investment indicates this isn’t going away anytime soon.

I’m a supporter of market dynamics in the law, but in the sale and management of lawyers’ services and practices, not in the underlying tort system itself. And while most everyone would agree that the system needs reform of some kind, this isn’t it. Plaintiffs’ lawsuit investment is already a potentially dangerous development by itself, but by giving it an equal and opposite dance partner on the defence side, we could be opening a very nasty Pandora’s Box inside the justice system.

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One Response to “Lawsuit investment and the limits of innovation”

  1. Craig Burley

    And here I was, literally just yesterday (it was in the train home) warning a young lawyer about both the theoretical and actual dangers 0f champerty.

    I guess the insatiable desire of the capital markets for a piece of everyone’s action (figuratively and, in this case, literally) is just going to make the small matter of the ethical conduct of a suit entirely dispensable. Plaintiffs and lawyers will gradually become forbidden to act other than in furtherance of their shareholders’ pecuniary interest, and the corporatization of justice will be complete.

    In Ontario, at least, I would hope that the state of the law remains clear. Champerty is no longer a crime, but such agreements are void where there is an improper motive, and speculative investment is surely the very definition thereof. Hopefully there are still some teeth in the old girl yet.

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