The economic case for third-party litigation financing

The US is often described as overly litigious, and it’s true that there need to be better methods to disincentivize frivolous lawsuits. However, individuals and businesses also struggle to finance meritorious litigation against practices that harm consumers and entrepreneurs.

When a person suffers wrongdoing by individuals, corporations, or, often, the government, the financial incentives to litigate are frequently prohibitive. They need to not only bear costly litigation expenses but also risk losing the legal action and the money invested in it. Thankfully, third-party litigation financing (TPLF) has emerged as a market mechanism to ease this financial burden for non-wealthy individuals and small businesses.

TPLF, for instance, was essential in helping Infrastructures for Information Inc. (i4i), a software company specializing in document processing for XML – a file format for structured data – obtain patent damages reparation from Microsoft. i4i had proprietary technology which facilitated editing XML documents, and it claimed that Microsoft had violated its patent with Microsoft Word. i4i couldn’t afford the costs to litigate against Microsoft, so Northwater Intellectual Property Fund provided funding for i4i to sue. In the end, the court awarded i4i $290 million in damages — more than 2,230 times Microsoft’s initial $130,000 settlement offer.

TPLF first emerged in Australia in the mid-1990s and has since spread to Europe and the US. In TPLF, an external entity like an investment firm pays for the plaintiff’s legal costs in exchange for a percentage of the proceeds if the case is successful. If the action is lost, the entity absorbs all the costs, shielding the plaintiff from the expenses. In recent years, TPLF has become the target of several concerns. Specifically, critics have pointed out a lack of transparency, an alleged increase in the number of mass tort lawsuits, and a potential decrease in reasonable resolutions achieved.

In traditional litigation, the court assumes the interest behind the lawsuit to be that of the plaintiff. However, TPLF introduces a second party — the funder — with another motive: profit. Some argue profit motives can be harmful to the legal process since courts cannot see this hidden interest. However, the data shows that these interests are aligned, as the invisible hand of the market brings together plaintiffs looking for financial compensation and funders seeking to profit.

Critics of TPLF charge that funders reject settlements that would have otherwise been accepted by plaintiffs to obtain a higher sum. This may sometimes happen, but in a meritorious case, is this really so bad? The plaintiff, after all, will also receive a greater amount in a higher settlement or jury verdict. TPLF is an investment for the funder, meaning funders are unlikely to reject a settlement in the absence of a higher expected return.

This payout optimization leads some to claim that TPLF may reduce the number of reasonable resolutions achieved, increasing societal costs. Looking at the incentive structure, the presence of the profit motive could reasonably contribute to increasing the payout. However, these higher amounts are what jurors consider appropriate given the case’s circumstances, unaware of third-party financing. TPLF is simply allowing plaintiffs to enforce their legal rights that wouldn’t otherwise be pursued due to their lack of resources to go through a legitimate legal claim.

Another critique is the claim that TPLF increases mass tort lawsuits, overwhelming businesses with their costs. Although TPLF may raise corporations’ litigation expenses, it would do so by allowing victims who previously couldn’t afford litigation to pursue their claims in court. In Underwood Ranches v. Huy Fong Foods, TPLF allowed Underwood Ranches to continue its legal challenge after Huy Fong Foods, a major sriracha sauce company based in California, suddenly terminated a nearly 30-year contractual relationship that had been maintained through oral agreements. Underwood Ranches had expanded its crops and adjusted its farming priorities to accommodate Huy Fong Foods’ growing demand and was suddenly left with unsellable crops. Underwood Ranches lost 80 percent of its revenues and laid off 55 percent of its workers but eventually secured a $23.3 million payout with the help of TPLF.  

The claim that TPLF increases frivolous claims finds little support from empirical data. Instead, in the Arizona State Law Journal article,  “Economic Conundrums in Search of a Solution: The Functions of Third-Party Litigation Finance,” Emory University law professor Joanna M. Shepherd and Judd E. Stone II, former solicitor general of Texas who clerked for Supreme Court Justice Antonin Scalia, argue that funders have strong incentives to avoid frivolous cases, since they’re unlikely to return the same profit that meritorious ones would.

To reach this conclusion, the authors used economic theory to analyze the incentives and behaviors underlying TPLF, reviewed the structure of litigation agreements, and analyzed academic literature and industry data to evaluate how TPLF operates in practice. Among their main findings were that TPLF allows meritorious claims that would otherwise be abandoned to be pursued, incentivizes funders to invest in stronger cases, and shows that many of the common criticisms of TPLF are unsupported.

TPLF is a free-market innovation that allows previously underserved litigants to pursue their claims. Constraining TPLF would prevent such groups from pursuing justice, further skewing access to the legal system toward the financially well-off.