The Economic Case Against Forced Disclosure of Third Party Litigation Funding
2.11.2022
Keith Sharfman is professor of law and director of bankruptcy studies at St. John’s University School of Law, where he teaches courses in law, economics and finance.
“How did you pay for that?” has always been an inappropriate question in American social life. Whether the inquiry is about the purchase of a house, a car, jewelry, an education or almost anything else, reasonably fair-minded people do not feel compelled to answer such a question and, in so doing, compromise their financial privacy. Why should a curious questioner be entitled to know whether you paid for something yourself out of income or savings, or if instead you purchased it on credit or with borrowed funds, or if instead you received the item as a gift from a friend or a relative? So long as the money used to make a purchase wasn’t stolen, how the purchase was funded is nobody’s business.
Until recently, this basic norm of financial privacy was as true for the purchase of legal services as it was for anything else. No one (and certainly not adversaries in a civil suit) used to think that they had the right to know how a party obtained the funding to finance its case. Whether litigation is funded with a party’s own funds, or with borrowed funds, or by means of a contingent or alternative fee structure agreed to by the party’s attorneys was never the concern of anyone other than the client and its attorneys.
Financial privacy is not protected, of course, when party finances directly bear on litigation outcomes, such as in bankruptcy and family law litigation where party financial disclosures are necessary and routine. But in the vast majority of cases, where litigation funding is legally irrelevant to case outcomes, preserving party financial privacy has always been the norm.
Generally speaking, the last thing a party wants an adversary to know is that it cannot afford to prosecute or defend its case or that its case is not strong enough to attract much if any external funding. Adversaries who know this information can try to use it to win not on the merits, as the legal system intends, but instead through a battle of attrition.
While it might well interest an adversary strategically to know how (and how well) cases are funded, the law never entitled an adversary to know. Just as the law does not entitle an employer, when negotiating a salary with a prospective employee, to know how badly the job seeker needs the job, so too, for reasons of strategic fairness that go beyond simply an interest in financial privacy, the law did not in the past grant parties any mandatory access to information about an adversary’s sources of funding. When litigating or negotiating a settlement, parties could rest assured that their adversaries would not have access to strategically compromising information concerning how the cases against them were funded.
All of this has changed, however, with the passage in a handful of jurisdictions (most recently in the Federal District of New Jersey) of procedural rules mandating the disclosure of third party litigation funding.[1] Under these unprecedented new rules, parties must now disclose the nature and extent of any third party funding that their cases receive.
The same rule change mandating the disclosure of nonparty litigation funding has been proposed in other jurisdictions such as Wisconsin, where it was adopted,[2] and Texas, where it has failed to pass.[3] In New York, no such rule or legislation has been proposed, but the New York City Bar Association’s Working Group on Litigation Funding has studied the issue and recommended against mandatory financial disclosure.[4]
Surprisingly, the Institute for Legal Reform (ILR) at the U.S. Chamber of Commerce (which usually favors free markets and opposes intrusive policy mandates and overbroad regulations that interfere with industry’s ability to engage in private market transactions) has lobbied heavily in favor of these new forced disclosure rules. The ILR’s website has gone so far as to describe “[f]ighting against the expansion of the multibillion [dollar] Third Party Litigation Funding (TPLF) industry here in the U.S. and globally” as one of its goals.[5] Though it is itself an industry, litigation finance is singled out by the ILR, perhaps because some influential members of the chamber are opposed to all litigation of any sort however meritorious it may be.
While on its website the ILR is candid about its goal to curtail litigation finance, the ILR’s public filings are framed more high-mindedly. In a recent filing with the New Jersey courts, the ILR offered a number of ostensible policy justifications for forced disclosure.[6] These included: (1) “to ensure compliance with ethical obligations” relating to “conflict[s] of interest,” “appearances of impropriety,” and “inappropriate fee sharing”; (2) to “satisfy defendants’ entitlement to know their accusers”; (3) to “allow both courts and defendants to more accurately evaluate settlement prospects and to better calibrate settlement initiatives” such as requiring litigation funders “to attend . . . mediation”; (4) to “give courts necessary information to assess who actually controls a civil action”; and (5) to “enable courts to determine whether funding arrangements are running afoul of state-law prohibitions against champerty.”
Even a cursory review of these justifications, however, finds them seriously deficient:
- Ethics. The ethics rules that the ILR invokes are designed to protect clients from their lawyers, not to protect parties from their adversaries’ financiers. If there is an ethical concern about attorneys’ fee structures or their arrangements with litigation funders, it is appropriate for their clients but not for their adversaries to complain. The problem of attorney ethics and conflicts is more than adequately met by Rule 7.1 and other extant Rules of Professional Conduct; additional disclosure targeted at litigation funders would not improve attorney ethics but rather would merely benefit the funded parties’ adversaries.
- Confrontation of Accusers. It is the clients themselves and not those who fund them who are the actual accusers. Defendants have no right to confront funders. There is no basis for confronting litigation funders in law or in history prior to the recent legal assault against litigation finance. The ILR seeks to portray financed parties as Goliaths rather than Davids. But what’s relevant for factfinders is whether these parties were Davids at the time of the alleged wrongdoing that is the subject of dispute, not whether they have obtained a Goliath level of funding to pursue litigation after the fact. And besides, litigation should always be about the merits themselves, not about which side is better funded or whether one side or the other seems more Goliath- or David-like.
- Settlement Prospects. It is doubtlessly true that any party in litigation would appreciate the opportunity to better “evaluate settlement prospects” and “calibrate settlement initiatives.” But since when has this ever been a legal entitlement? Never before has the law adopted procedural rules with an intention to strengthen the hand of one party so that it can settle more favorably with the other. Procedural rules are supposed to enhance the legal system’s ability to adjudicate disputes on the merits, not to tilt outcomes in one direction or another.
- Control of the Case. When a court finds that ethical misconduct may have occurred in a particular case, it is indeed sometimes necessary for the judge to learn who is really in control of the case. But an inquiry as to control is justified only in such narrow circumstances and not as a blanket rule mandating disclosure in all cases, including the vast majority where no ethical impropriety ever occurs or is even alleged. Consider also that we have professional rules to govern attorneys, and we rely on attorneys to sign pleadings and implicitly vouch for the accuracy of the statements they contain. The rules do not presume dishonesty. Just as it would not be appropriate to audit all taxpayers but rather only those whose filings raise a reasonable suspicion of illegality, we should not presumptively investigate litigation financing in all cases but rather only in the rare case where circumstances suggest to a neutral judge a specific area of ethical concern.
- Champerty. Champerty is an ancient doctrine that made it a crime for a third party to support someone else’s litigation. The doctrine has been abandoned in most jurisdictions, including New Jersey. But even for those jurisdictions where champerty remains forbidden in some form or another, the proper approach is to investigate in specific cases where champerty is suspected or alleged in good faith, not to cast about widely with mandatory disclosures burdening all litigants and their funders across the board.
But the ILR’s non-merits-based objections to privacy for litigation finance are, in truth, a distraction. For the case against forced disclosure of litigation finance goes far beyond demonstrating that disclosure is both unprecedented and unnecessary to police against the harms that such financing allegedly enables. Further analysis from an economic perspective shows that maintaining the privacy of litigation finance is economically efficient and actually beneficial from a social welfare perspective.
Economists and policymakers have long recognized the general economic value of financial privacy.[7] Consumers and other economic actors are often willing to pay for financial privacy, and policymakers routinely seek to protect it. The policy debate on financial privacy has always been about whether to allow the waiver of it and not about whether to require its relinquishment. And what is true for financial privacy as a general matter is even more true when it comes to financial privacy with respect to litigation finance.
Litigation finance information is of particular strategic value. The extent and nature of a party’s litigation funding can affect the strength with which a case may credibly be pursued or settled.[8] Why should the law entitle adversaries to have access to this information and enable them to draw inferences from it about the strength of their opponents’ cases and about the vigor with which their opponents are equipped to pursue their claims? Why should an adversary get to know how funders regard the claims they fund and, implicitly, how they value other claims that they do not fund?
Litigation funders invest time, effort and other resources to research the value of the claims they fund. This is socially valuable activity, as it enables meritorious claims to be vindicated that otherwise would lack the funding to go forward.[9] Compelling litigation funders to share the results of their research with their litigation opponents and/or other competitors through mandated disclosures of their case selections and fee arrangements diminishes the value of this research and funding activity and dampens the incentive to engage in it.
The same analysis holds true for any socially valuable research performed by any firm in any industry. Imagine if pharmaceutical firms had to disclose to each other the nature and extent of the funding that they devote to their research projects. Competitors could then use these disclosures to their own advantage, and the incentive for any firm to develop new drugs would thereby be diminished. In economics, this obvious problem is referred to as “free riding” – a principle that animates the law’s protection of trade secrets and other intellectual property and one that is well understood and accepted by policymakers when regulating industry.[10] Litigation funders face the same risks of free riding as other innovators and thus ought also to enjoy the same legal protections.
Beyond the problem of free riding in cases where litigation funding is available, forced disclosure of litigation finance also destroys value when litigation finance is lacking. Opposing parties in litigation can draw an adverse inference about the value of a case from the absence of external litigation finance. This problem has not been sufficiently appreciated until now in the policy debate, because unfunded claims lack a natural advocate to lobby on their behalf in the policy arena.
The problem of adverse inferences is well known in economics generally and as applied specifically to civil litigation.[11] Consider by way of example two types of anti-theft systems for automobiles. One involves a device that rests atop a car’s steering wheel and is visible to prospective car thieves. The other is a hidden system that silently messages police when a car is stolen. Suppose that the two devices protect the cars in which they are installed equally well. But what effect do these devices have on other cars that are not equipped with an anti-theft device?
The visible device affords no protection to other cars and, indeed, may harmfully encourage car thieves to focus their efforts on cars that lack visible protection. The hidden device, by contrast, protects not only the car in which it is installed but also other cars that, from an external observer’s point of view, might have the hidden device – even if they do not.[12]
Now consider a world in which the hidden anti-theft device is banned by regulators. In such a world, prospective car thieves peering through a car window will know that if no anti-theft device is visible, the car is unprotected. When concealment of anti-theft devices is banned, the prospective car thief can draw an adverse inference from the absence of a visible device. Crooks would, of course, benefit from knowing whether an intended victim has a security system. But obviously, the law should not give them the right to know.
Similar economic analysis applies (albeit more controversially) in the case of concealed carry gun laws. Violent crime is lower in jurisdictions that allow legal gun owners to carry concealed weapons because the legal possibility of a concealed weapon deters violence even against people who are not necessarily carrying a weapon but who (from a potential attacker’s perspective) simply might be. [13] Here too, concealment is socially beneficial (excluding from the analysis the possible negative effects that permitting concealed weapons may have on gun accidents, a factor that is possibly present only in the gun but not in the litigation finance context).
Litigation finance privacy has salutary economic properties that are analogous to those of concealed weapons and hidden anti-theft devices in automobiles. The concealment of potential litigation finance makes it much harder for well-funded civil litigants to take advantage of poorly funded civil litigants through the adoption of hardball litigation tactics based on adverse inferences about the case from its lack of external funding. As with hidden anti-theft devices and concealed carry gun laws, the possibility and permissibility of concealed litigation funding protects against harmful, opportunistic conduct by adversaries and is protective even in cases when concealment is not present. And when concealment is legally unavailable, adversaries may harmfully draw adverse inferences as to a lack of protection.
Forced disclosure of litigation finance denies financial privacy to civil litigants and thereby diminishes their litigation prospects. Economic analysis shows how this is true even for litigants who do not avail themselves of financing. Preserving financial privacy for litigants protects not only parties whose cases attract external litigation finance, but also (and perhaps even more importantly) those whose cases do not.
Economics teaches us that the law should not be used to attack litigation finance privacy but rather to protect it. This would allow judges and juries to decide cases on the merits rather than on the basis of how cases are funded. Asking parties how they paid for their cases is not merely rude. Requiring them to answer is economically wasteful and socially harmful.
[1] Local Rule 7.1.1 of the U.S. District of New Jersey.
[2] See 2017 Wisconsin Act 235 §12 (requiring litigation parties to disclose any agreement entitling someone other than party attorneys to receive compensation that is contingent on proceeds from a civil action).
[3] https://capitol.texas.gov/BillLookup/History.aspx?LegSess=86R&Bill=SB1567 (visited Feb. 9, 2022).
[4] New York City Bar Association Working Group on Litigation Funding, Report to the President 72-73 (Feb. 28, 2020), documents.nycbar.org/files/Report_to_the_President_by_Litigation_Funding_Working_Group.pdf.
[5] https://www.uschamber.com/program/institute-for-legal-reform (visited Feb. 6, 2022).
[6] See Letter of Harold Kim & Anthony Anastasio re: Proposed Local Civil Rule 7.1.1. – Disclosure of Third-Party Litigation Funding (D.N.J.) (May 21, 2021).
[7] Jeffrey M. Lacker, The Economics of Financial Privacy: To Opt out or Opt in, Federal Reserve Bank of Richmond Economic Quarterly 1-16 (2002). On the value of privacy in the context of litigation and settlement, see generally Omri Ben-Shahar & Lisa Bernstein, The Secrecy Interest in Contract Law, 109 Yale Law Journal 1885 (2000).
[8] Richard A. Posner, Economic Analysis of Law § 22.12 (9th ed. 2014); Lucian Arye Bebchuk, A New Theory Concerning the Credibility and Success of Threats to Sue, 25 Journal of Legal Studies 1 (1996).
[9] Ronen Perry, Crowdfunding Civil Justice, 59 Boston College Law Review 1357 (2018); James D. Dana, Jr. & Kathryn E. Spier, Expertise and Contingent Fees: The Role of Asymmetric Information in Attorney Compensation, 9 Journal of Law, Economics, & Organization 349 (1993).
[10] See, e.g., Richard A. Posner, Economic Analysis of Law 363 (9th ed. 2014); Benjamin Klein & Andres V. Lerner, The Expanded Economics of Free-Riding: How Exclusive Dealing Prevents Free-Riding and Creates Undivided Loyalty, 74 Antitrust Law Journal 473 (2007); Laurie L. Hill, The Race to Patent the Genome: Free Riders, Holdups, and the Future of Medical Breakthroughs, 11 Texas Intellectual Property Law Journal 221 (2003); Daniel B. Ofstedal, Eliminating Truckers’ Free Ride Through Trademark Control, 13 Journal of Corporation Law 621 (1988); Victor P. Goldberg, The Free Rider Problem, Imperfect Pricing, and the Economics of Retailing Services, 79 Northwestern University Law Review 736 (1984).
[11] Abraham L. Wickelgren, A Right to Silence for Civil Defendants?, 26 Journal of Law, Economics, & Organization 92 (2008); Kathryn E. Spier, Incomplete Contracts and Signalling, 23 Rand Journal of Economics 432 (1992); cf. Daniel J. Seidmann & Alex Stein, The Right to Silence Helps the Innocent: A Game Theoretic Analysis of the Fifth Amendment Privilege, 114 Harvard Law Review 430, 487 (2000).
[12] Ian Ayres & Steven D. Levitt, Measuring Positive Externalities From Unobservable Victim Precaution: An Empirical Analysis of Lojack, 113 Quarterly Journal of Economics 43 (1998) (demonstrating empirically how the hidden anti-theft system Lojack benefits other car owners who do not possess the Lojack system).
[13] John R. Lott, Jr., More Guns, Less Crime: Understanding Crime and Gun-Control Laws (University of Chicago Press, 3d ed., 2010) (documenting empirically how laws permitting gun owners to carry concealed weapons reduce the incidence of murder and other violent crimes though they may also increase gun accidents).
