Litigation Finance, Litigators, Money

Finance And Law: First Salvos On Litigation Funding Disclosure

How should litigation funders feel about courts compelling disclosure of their roles in cases?

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gavel money litigation financeThe first salvos against third-party litigation funding disclosure are being fired. Historically, litigation funders have been able to rely on the shield of confidentiality agreements to protect their identities from public scrutiny. That secrecy has been a double-edged sword: it has kept the wraps on the industry, deterring major new entrants but at the same time limiting publicity, which might bring in greater interest from institutional investors.

While the litigation market overall is roughly $30 billion annually, the aggregate value of all third-party litigation funders is only a few billion dollars. In other words, the industry could grow a dozen-fold before it begins to run up against a dearth of investment opportunities given typical price-to-sales ratios. Typically, litigation funding firms have been so publicity shy that they have avoided opportunities that would enhance their own market value and benefit shareholders. Based on a recent judge’s ruling, that mindset looks like it will have to change, whether the firms like it or not.

Judge Susan Illston of the U.S. District Court for the Northern District of California recently granted defendant Chevron’s motion to compel the plaintiff to reveal the identity of who was funding its proposed class action regarding a gas explosion off the coast of Nigeria in Gbarabe v. Chevron Corp., No. 14-CV-173 (N.D. Cal. Aug. 5, 2016). This finding in a class action suit is significant. If the funding agreement here is relevant in determining the adequacy of class counsel, then it is likely that other judges in the future may feel compelled to require the disclosure of third-party funder identities as well. With this precedent in place, litigation funders will be forced to change their playbooks.

At least part of the resistance by litigation funding firms to disclosure has been based on the legal industry’s ongoing debate over the ethics of litigation funding. As a financial economist, I prefer to leave such debates to the philosophers, but it is clear that funders are going to have to accept that many in the legal profession hold personal qualms against such funding. In that sense, the disclosure of litigation funders could actually help the industry. A good parallel here is the hedge fund industry – hedge fund managers resisted SEC disclosure for years until new legislation following the financial crisis. That change has actually been an enormous boon for the industry, as assets under management have swelled thanks to greater investor confidence in the industry.

In addition to secrecy concerns, though, I suspect that some litigation funders wish to avoid disclosure due to concerns about their ethical reputation among peers. If litigation funding becomes viewed as questionable in the same way that some other industries and practices are (such as payday lending, gambling, or tobacco), it would likely boost returns in the field. Many empirical finance studies, including one I did with a coauthor several years ago, have examined the returns to these types of “sin” industries. The conclusion has generally been that returns in sin industries rise as public disapproval rises. In other words, asset prices fall relative to the profitability of the underlying investment, which in turn boosts returns.

In the Chevron case, the plaintiff’s attorneys initially produced only a heavily redacted version of the funding agreement. After further arguments, the judge ordered the production of the full unredacted agreement, along with any other relevant documents. The knee-jerk reaction from the funding industry will be horror. That response is wrong-headed. If this precedent spreads, it will create an unpleasant debate for those inside the legal industry. But it will be good for investors and ultimately the industry overall by bringing in more institutional capital and boosting returns thanks to greater transparency. Investors should cheer these developments even as funder firms squirm in discomfort.

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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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