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  • THE LITIGATION FINANCE CONTRACT

    MAYA STEINITZ*

    ABSTRACT

    Litigation fundingfor-profit, nonrecourse funding of a litigationby a nonpartyis a new and rapidly developing industry. It has beendescribed as one of the biggest and most influential trends in civiljustice today by RAND, the New York Times, and others. Despitethe importance and growth of the industry, there is a completeabsence of information about or discussion of litigation financecontracting, even though all the promises and pitfalls of litigationfunding stem from the relationships those contracts establish andorganize. Further, the literature and case law pertaining to litigationfunding have evolved from an analogy between litigation fundingand contingency fees. Much of that literature and case law views bothforms of dispute financing as ethically compromising exceptions tothe champerty doctrine. On that view, such exceptions create the risksof an undesirable loss of client control over the case, of compromisinga lawyers independent judgment, and of potential conflicts of inter-est between funders, lawyers, and clients.

    This Article breaks away from the contingency analogy and in-stead posits an analogy to venture capital (VC). It shows the strikingresemblance of the economics of litigation funding with the well-understood economics of VC. Both are characterized by extreme (1)uncertainty, (2) information asymmetry, and (3) agency costs. Afterdetailing the similarities and differences between these two types offinancing, this Article discusses which contractual arrangementsdeveloped in the area of venture capitalism can be directly applied to

    * Associate Professor, University of Iowa College of Law. I thank Herb Hovenkamp,Steve Burton, Todd Pettys, Michelle Falkoff, Tom Gallanis, Alan Morrison, Rob Rhee,Nathan Miller and the participants of the University of Iowa College of Law and Universityof Wisconsin Law School workshops for the comments. A special thanks to Victor Goldbergfor stimulating conversations about the similarity between venture capital and litigationfinance as well as comments on an early draft.

    455

  • 456 WILLIAM & MARY LAW REVIEW [Vol. 54:455

    litigation finance, which ones need to be adapted, and how suchadaptation can be achieved. As much of the theory, doctrine, andpractice of VC contracting can be applied or adapted to litigationfinance, practitioners and scholars can be spared decades of trialand error in developing standardized contractual patterns.

    In addition, the analogy turns most of the conventional wisdom inthe field on its head. This Article argues that funders should beviewed as real parties in interest, funders should obtain control overa funded litigation, and attorneys should take funders input intoaccount. In return, funders should pay plaintiffs a premium for thecontrol they receive, subject themselves to a compensation schemethat aligns their interests with those of the plaintiffs, and enhancethe value of claims by providing noncash contributions. Indeed, onthe suggested view, noncash contributionas much as if not morethan, capital contributionshould be seen as a key benefit of liti-gation finance. Courts and regulators should devise rules thatenhance the transparency of the industryin particular the perfor-mance outcomes of various litigation funding firms and their ethicalpropensities. Such a legal regime will foster the emergence of areputation market that will police the industry and support contrac-tual arrangements.

  • 2012] THE LITIGATION FINANCE CONTRACT 457

    TABLE OF CONTENTS

    INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459I. A CASE STUDY: BURFORDS INVESTMENT IN THE

    CHEVRON/ECUADOR DISPUTE . . . . . . . . . . . . . . . . . . . . . . . . . 465A. Background: The Chevron/Ecuador Dispute . . . . . . . . . . 466B. The Investment Structure . . . . . . . . . . . . . . . . . . . . . . . . . 467C. The Distribution of Control Between

    Burford and the Ecuadorian Claimants . . . . . . . . . . . . . . 471D. Staged Financing and Right of First Refusal . . . . . . . . . 473E. Information Sharing, Duty to Cooperate, and

    Common Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474F. Negative Covenants, Representations, and

    Warranties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 476G. Operational Efficiencies . . . . . . . . . . . . . . . . . . . . . . . . . . . 479

    II. THE ECONOMICS OF LITIGATION FINANCE . . . . . . . . . . . . . . . 479A. The Litigation Finance-Venture Capital

    Analogy in a Nutshell . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479B. Ethical Bounds to Third-Party Profit Making in

    Litigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483C. Information Asymmetry and Agency Costs . . . . . . . . . . . . 488D. Legal Claims as Assets and Extreme Uncertainty . . . . . . 490

    III. VENTURE CAPITALS LESSONS LEARNED:CONTROLLING EXTREME UNCERTAINTY, INFORMATION ASYMMETRY, AND AGENCY COSTS THROUGH ORGANIZATIONAL AND CONTRACTUAL ARRANGEMENTS . . . . . 496A. Recommended Organizational Structure . . . . . . . . . . . . . 496

    1. Limited Partnerships and Syndication . . . . . . . . . . . . . 4962. Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4973. Noncash Contribution . . . . . . . . . . . . . . . . . . . . . . . . . . 498

    B. Recommended Contractual Structure . . . . . . . . . . . . . . . . 5011. The Litigation Finance Fund-Investor Contract . . . . . . 501

    a. Control and Compensation . . . . . . . . . . . . . . . . . . . . 501b. Mandatory Distributions and Liquidation . . . . . . . . 502

  • 458 WILLIAM & MARY LAW REVIEW [Vol. 54:455

    2. The Litigation Finance Fund-Plaintiff Contract . . . . . 503a. Staged Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504b. Role in Management . . . . . . . . . . . . . . . . . . . . . . . . . . 507c. Negative Covenants . . . . . . . . . . . . . . . . . . . . . . . . . . . 509d. Highly Incentivized Compensation,

    Exit, and Reputation . . . . . . . . . . . . . . . . . . . . . . . . . 5103. The Attorney Retention Agreement . . . . . . . . . . . . . . . . 515

    CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517

  • 2012] THE LITIGATION FINANCE CONTRACT 459

    INTRODUCTION

    Litigation financefor-profit, nonrecourse funding of a litigationby a nonpartyis a new and rapidly developing industry globally,and in the United States in particular.1 So much so, that the RANDInstitute for Civil Justice has dubbed it one of the biggest and mostinfluential trends in civil justice,2 and the New York Times hasrecently reported on it at length on its front page and in its Bettingon Justice series.3 More generally, litigation funding in all of itsformslaw lending, contingency fees, and nonrecourse fundingispivotal for understanding civil litigation as a whole: [T]he most ...important phenomena of modern litigation are best understood asresults of changes in the financing and capitalization of the bar.4For example, in the United States a market in bankruptcy claimsemerged some twenty years ago and nothing has changed the faceof bankruptcy in the last decade as much as the new-found liquidity

    1. New York City Bar Assn, Formal Op. 2011-2 I (2011) (As of 2011, [the third-partylitigation financing] industry has continued to grow, both as to the number and types oflawsuits financed and financing provided. The aggregate amount of litigation financingoutstanding is estimated to exceed $1 billion.). On trends in law firm finance, see LarryRibstein, The Death of Big Law, 2010 WIS. L. REV. 749, 754-59, 788-97 (discussing bothtraditional and emerging law firm models).

    2. Third Party Litigation Funding and Claim Transfer, RAND CORP., http://www.rand.org/events/2009/06/02.html (last visited Oct. 10, 2012); see also Maya Steinitz, WhoseClaim Is This Anyway? Third-Party Litigation Funding, 95 MINN. L. REV. 1268, 1270-71 & n.4(2011). Litigation funding is accelerated by the global recession, which has created moreclaims but less funds to pursue them as well as an appetite for new, alternative assets. Seeid. at 1283-85. The expansion of litigation funding is also driven by a global transformationof legal services egged on by the Legal Profession Act 2004 (NSW) ch 2, pt 2.6, div 2, whichallows incorporation of legal practices in Australia, and the Legal Services Act, 2007, c. 29, 71-111, which allows investment in British law firms.

    3. E.g., Binyamin Appelbaum, Investors Put Money on Lawsuits to Get Payouts, N.Y.TIMES, Nov. 15, 2010, at A1. The report was accompanied by Susan Lorde Martin, Op-Ed.,Leveling the Playing Field, N.Y. TIMES (Nov. 15, 2010), http://www.nytimes.com/roomfordebate/2010/11/15/investing-in-someone-elses-lawsuit/leveling-the-playing-field, andwas followed by an additional report on the finance of divorce litigation. See BinyaminAppelbaum, Taking Sides in a Divorce, Chasing Profit, N.Y. TIMES, Dec. 5, 2010, at A1; seealso Peter Lattman & Diana B. Henriques, Speculators Are Eager to Bet on Madoff Claims,N.Y. TIMES DEALBOOK (Dec. 13, 2010), http://dealbook.nytimes.com/2010/12/13/speculators-are-eager-to-bet-on-madoff-claims/ (discussing how investment firms are attempting to buytrustee-approved claims against Bernard L. Madoff).

    4. Stephen C. Yeazell, Abstract, Refinancing Civil Litigation, SOC. SCI. RES. NETWORK(June 18, 2002), http://papers.ssrn.com/so13/papers.cfm?abstract_id=315759.

  • 460 WILLIAM & MARY LAW REVIEW [Vol. 54:455

    in claims.5 Due to litigation fundings increasing salience, courts,legislatures, regulators, and academics have all, as of late, startedgrappling with the phenomenon head on

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