Litigation Finance, Litigators, Money

Finance And Law: How Does Litigation Finance Influence Attorneys?

Does turning to litigation finance make good lawyers better, or does it make all lawyers worse at their job?

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scales of justice money law legal business financeDoes turning to litigation finance make good lawyers better? Does it make all lawyers worse at their job? Or is it merely a financing tool that is little different than a bank loan? The answers to these questions are critical to attorneys, clients, investors, and society as a whole. Despite this, there is very little economic theory let alone empirical evidence on the issue.

As a professor of finance, a consultant to investment firms, and an occasional expert witness, I’m currently in the process of looking at data around this issue for an eventual research study on the topic. For this week’s column, I thought it worth laying out what economic theory says about the impacts of litigation finance and how it should be optimally structured to maximize value for both investors and attorneys.

Litigation finance is one of the hottest and most controversial innovations in the business of law in the last couple of decades. For anyone who is unfamiliar, the basic premise of litigation finance is that outside investors put money into a law firm in exchange for a share of profits from cases that are completed in the future. The exact structure of the transactions varies but there are a few commonalities.

How Much Should Lawyers Ask for from Investors?

First, litigation finance is often done on the prospects around a single lawsuit. That’s not always the case, though, as the Gerchen Keller Capital investment in AkinMears shows. Second, investors generally only get a payout if the law firm wins the designated case — there is usually no residual claim on the value of the law firm itself or its future cases. In that sense then, a litigation finance investment is best thought of as an OTC call option on a given case, and it should be valued accordingly.

Determining the “value” of a lawsuit in exchange for an investment is not quite as simple as using a Black Scholes formula though, since some of the inputs aren’t obvious. That leaves binomial options pricing or Monte Carlo simulations as the best choice for both attorneys and investors when haggling over the investment amount and prospective payout. The math in both cases is not that hard, but it does require some careful analysis.

What Happens To Lawyers Who Accept Litigation Funding?

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The answer to this controversial question is “it depends.” If a contract is specified correctly, my preliminary research suggests lawyers are actually more likely to win cases when backed by litigation funding. On the other hand, if incentives aren’t properly managed, litigation funding actually diminishes attorney effort by reducing the pressure to win.

Overall then, litigation funding can either make good lawyers better or bad lawyers worse. A carefully structured investment contract which creates specific benchmarks that attorneys must meet to receive future funding on future cases enhances attorney effort and provides additional resources that can make all the difference in a big case. On the other hand, the average funding vehicle from some large litigation finance firms actually lack the appropriate economic mechanisms to enhance attorney effort. This creates a problem — attorneys have less skin in the game on the lawsuit so they don’t have to perform as highly, but they do have access to more resources. The end results in these typical investments then is that the two effects are opposing which creates the possibility of either an effective or perverse set of outcomes for both attorneys and investors.

Litigation Finance Effects on the Legal Profession

Litigation finance unambiguously reduces barriers to entry in the large class-actions case market which in turn creates more competition in that market. The result is more attorneys pursuing the same number of cases which leads to fewer cases for the average attorney and more variation in pay for attorneys over time. That likely makes the litigation profession less attractive for the typical individual coming out of law school.

A lot more could be said about litigation finance, and I’ll likely return to this topic in a future column. For now, attorneys and investors thinking about entering into litigation finance arrangements should be careful to think through the economic and financial valuation issues that this new type of investment creates.

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(Anyone interested in discussing this week’s column may email me at M.McDonald@MorningInvestmentsCT.com or MMcDonald8@Fairfield.edu.)

Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at M.McDonald@MorningInvestmentsCT.com.

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