Deminor Wiki - Legal Financing

Overview

The practice of legal financing is most commonly associated with civil litigation, including commercial disputes, class actions, insolvency proceedings, and international arbitration. In the United States, litigation funding is also widespread in personal injury and mass tort claims, which constitute one of the largest segments of the market. In Europe, collective redress mechanisms such as the Dieselgate litigation have driven significant growth. It is distinct from traditional forms of legal fee arrangements, such as contingency fees or conditional fee agreements, as the funder is a third party with no direct involvement in the legal representation of the client. The growth of legal financing has contributed to greater access to justice, the levelling of the playing field between parties of unequal financial resources, and the development of a sophisticated market for legal claims as financial assets.

Beyond its traditional area of commercial disputes, legal financing has also evolved into other areas of disputes, such as inheritance law, family law, or medical malpractice claims, often being offered by highly specialised funders with specific experience and expertise in the respective field.

History

The origins of legal financing can be traced to the common law doctrines of maintenance and champerty, which historically prohibited third parties from supporting litigation in exchange for a share of the proceeds. These doctrines were rooted in concerns about the potential for abuse, frivolous litigation, and interference with the administration of justice. Over time, however, many common law jurisdictions have relaxed or abolished these prohibitions, recognising the potential benefits of third-party funding in promoting access to justice and efficient dispute resolution. While these doctrines were influential in common law jurisdictions, many civil law countries (e.g., Germany, France) never applied them in the same way, and the general admissibility of seeking third-party funding for the pursuit of a claim has never seriously been put into question,

The modern legal financing industry began to take shape in the late 20th century, initially in Australia and the United Kingdom. In Australia, the relaxation of restrictions on “Maintenance and “Champerty” in the 1990s paved the way for the emergence of professional litigation funders, particularly in the context of class actions. The United Kingdom followed suit, with significant legal and regulatory developments in the 2000s facilitating the growth of the sector. The United States, while having a different legal tradition, has also seen the rise of legal financing, particularly in the form of non-recourse advances to plaintiffs in personal injury and commercial cases.

Today, legal financing is a global industry, with funders operating in numerous jurisdictions across Europe, North America, Asia, and beyond. The industry has evolved from its early focus on single-case funding to encompass portfolio financing, law firm lending, and the securitisation of legal claims.

Types of Legal Financing

Legal financing encompasses a range of funding models, each tailored to the needs of different litigants and types of disputes. The principal forms include:

• Single-case funding: The funder provides capital to support a specific legal claim or defence. The funding may cover legal fees, disbursements, expert witness costs, and other litigation expenses.
• Portfolio funding: A law firm or corporate client receives funding secured against a portfolio of cases, spreading risk and potentially reducing the cost of capital. This can also include a mix of active and passive claims, allowing the client to also have the cost of defending litigation covered by the funder.
• Law firm financing: Funders may provide working capital or credit facilities to law firms, secured against future receivables or contingent fee arrangements. However, in some jurisdictions, especially such with a civil law tradition, concerns about lawyer independence and professional conduct rules may limit or restrict its use.
• Defence-side funding: Although less common, some funders offer financing to defendants, particularly in cases where there is a counterclaim or the defendant faces significant financial exposure.
• Consumer legal funding: In the context of personal injury or small claims, individuals may obtain advances against expected settlements to cover living expenses or medical bills.
• Appeal funding: Funding may be provided specifically for the costs associated with pursuing or defending an appeal.

Litigation Funding Context

Litigation funding is a subset of legal financing and refers specifically to the provision of capital for the prosecution or defence of legal claims. The funder assumes the financial risk of the litigation, typically on a non-recourse basis, meaning that repayment is contingent upon a successful outcome. If the case is unsuccessful, the funder loses its investment and the claimant is not required to repay the funding. This makes third-party funding very attractive for the client, yet also very risky for the funder, and explains why funders (must) apply a high level of scrutiny when assessing whether or not to support a claim.

The litigation funding process generally involves several stages:

1. Case assessment: The funder conducts due diligence to evaluate the merits of the case, the likelihood of success, but also on the potential damages, the creditworthiness of the defendant, the expected duration of the case, and the enforceability of any judgment or award.
2. Funding agreement: If the case is approved, the parties enter into a funding agreement setting out the terms of the financing, including the budget the funder agrees to provide, and the funder's entitlement to a share of the proceeds.
3. Ongoing monitoring: The funder may monitor the progress of the litigation, and offer to support in some areas of the case management that are not part of the core legal work on the case, but typically does not control the conduct of the case or the legal strategy.

Resolution and recovery: Upon a successful outcome, the funder receives its agreed share of the proceeds, typically structured as a percentage of recovery or a multiple of the amount invested, after deducting legal fees and other costs. If the case fails, the funder absorbs the loss. Litigation funding is particularly prevalent in high-value commercial disputes, international arbitration, insolvency proceedings, and collective actions. It enables claimants with meritorious claims but limited resources to pursue litigation against well-funded opponents, thereby promoting fairness and access to justice. The presence of a third-party funder can also influence the dynamics of settlement discussions, as it signals to defendants that the claimant has the resources to pursue the case to conclusion. However, the involvement of funders has also raised questions about potential conflicts of interest, control over litigation strategy, and the confidentiality of privileged information.

Market Impact

The legal financing industry has experienced significant growth over the past two decades, driven by increasing demand for alternative sources of litigation funding and the recognition of legal claims as valuable financial assets. The market is characterised by a diverse range of participants, including specialist litigation funders, hedge funds, private equity firms, and institutional investors.

Key impacts of legal financing on the legal market include:

• Increased access to justice: Legal financing enables individuals and businesses to pursue claims that they might otherwise be unable to afford, reducing the financial barriers to litigation.
• Risk management: By transferring the financial risk of litigation to a third party, claimants and law firms can manage their exposure and allocate resources more efficiently, allowing them to not make provisions in the balance sheet for the cost of litigation.
• Market discipline: Funders conduct rigorous due diligence before investing in cases, which can help to filter out unmeritorious claims and promote the efficient resolution of disputes.
• Innovation in legal services: The availability of external funding has encouraged law firms to develop new business models, such as contingency fee arrangements and alternative fee structures, subject to the respective legal framework in the jurisdiction they operate in.

The industry has also attracted significant investment, with some funders listed on public stock exchanges and others managing substantial pools of capital. The growth of the sector has led to increased competition, innovation in funding structures, specialisation, and the development of secondary markets for legal claims, however, the development of secondary markets for legal claims remains limited.

Regulation

The regulation of legal financing varies significantly across jurisdictions, reflecting differing legal traditions, policy considerations, and market maturity. In some countries, the industry is subject to specific regulatory frameworks, while in others it operates under general principles of contract, tort, and professional conduct.

• United Kingdom: The Association of Litigation Funders (ALF) is the self-regulatory body for the industry, with members required to adhere to a voluntary Code of Conduct. The Code sets out standards for capital adequacy, transparency, and the management of conflicts of interest. The courts have also developed principles to govern the use of third-party funding, particularly in the context of collective actions.
• Australia: The industry is regulated by the Australian Securities and Investments Commission (ASIC), with funders required to hold an Australian Financial Services Licence and comply with disclosure and conduct obligations.
• United States: Regulation is fragmented, no federal framework; regulation is state based by adopting varying approaches to the enforceability of funding agreements. Some states (such as New York and Delaware) restrict litigation funding under Champerty rules, others have enacted specific statutes for consumer litigation funding, while many permit commercial funding with relatively few restrictions.
• Europe: The European Parliament in 2022 called for binding regulation of TPF, especially in collective redress. However, no EU-wide legislation currently exists, leaving regulation largely to member states. In most member states, Litigation Funding as an industry is not subject to specific legislation, but some have opted to regulate certain areas in which funders are active, especially in the field of collective consumer claims.

Key regulatory issues include the protection of claimants' interests, the prevention of conflicts of interest, the disclosure of funding arrangements, and the maintenance of the independence of legal counsel. The industry has generally supported the development of clear and proportionate regulatory frameworks to promote transparency, accountability, and market confidence.

Broader Industry Context

Legal financing is part of a broader trend towards the financialisation of legal claims and the development of alternative legal service providers. The industry intersects with other areas of legal innovation, such as legal technology, alternative dispute resolution, and the unbundling of legal services. The industry intersects with related sectors such as legal expense insurance, after-the-event (ATE) insurance, and claims management solutions.

The industry continues to evolve, with funders exploring new markets, developing innovative funding structures, and expanding into related areas such as judgment enforcement and asset recovery.

The growth of legal financing has also prompted law firms to adapt their business models, most commonly by entering into strategic partnerships with funders or by assisting clients in securing funding, with some firms even establishing their own funding arms or entering into strategic partnerships with funders. The increasing availability of third-party funding has enabled law firms in countries where the professional attorneys’ rules allow for such arrangements, to offer clients a wider range of fee arrangements, including conditional fee agreements (CFAs), damages-based agreements (DBAs), and hybrid models, combining hourly and contingency fees.

Conclusion 

Legal financing represents a significant development in the modern legal landscape, offering new opportunities and challenges for claimants, law firms, funders, and regulators. By providing access to capital, managing litigation risk, and promoting market discipline, legal financing has the potential to enhance the efficiency and fairness of the justice system. As the industry continues to mature, ongoing attention to regulatory standards, transparency, and best practices will be essential to ensuring its continued growth and legitimacy.

Reviewed by:  Dr. Malte Stübinger, General Counsel Germany 

Disclaimer: The sole purpose of this article is for general information, and its contents should not be considered as legal advice, as legal frameworks / systems vary from country to country. The article is based on publicly available information and while care is taken in compiling this, no warranty, express or implied is given, nor does Deminor assume any liability for the use thereof.