Debt-Financed Litigation and Law Firm Size

by Mike Dorf

On Monday, the NY Times reported on the growing trend of relatively high-interest loans being extended by major financial players to plaintiffs' lawyers as a means of funding litigation.  The story raises a number of interesting issues.

1) On the plus side, such debt-financed litigation enables lawyers who otherwise could not afford to front the legal costs to poor clients to do so.  It therefore enables the bringing of some meritorious cases that otherwise would not be brought simply because of the prohibitive cost of litigation.

2) On the minus side, the article notes how the combination of high interest rates and lack of up-front disclosure to clients of debt financing  means that clients can end up paying a very substantial portion of any recovery to lenders.  In addition, there are real concerns about client confidentiality.  Investors need to see materials about the case in order to figure out whether it's worth investing in any given case, but disclosure to such third parties then makes it hard for the lawyer and client to maintain that the material is confidential/privileged.

3) The Chamber of Commerce--which systematically favors defendants--predictably warns against the dangers of this sort of arrangement, but this is obviously self-serving.  According to several experts with whom I spoke, defense firms sometimes use debt financing too, but the Chamber does not seem at all exercised about that.  (Debt-financing works somewhat differently for plaintiff firms and defense firms.  Money is lent to a plaintiff firm on the expectation of levying against the eventual judgment.  Money is lent to a defense firm on the expectation of levying against the client's income-stream after successfully defeating a liability claim to cover up-front defense costs that the client can't pay all at once.)

4) One might wonder why sophisticated investors are doing this now.  The answer I got from those to whom I talked is that this is part of a larger trend of hedge funds and others looking for investments that are not in any way correlated to the overall market.  As we learned a couple of years ago, a seemingly safe hedge can go south when there's enough inter-connectedness in the economy.  (E.g., going short on some asset only hedges against the risk that the asset will decline if the counter-party to your short position is able to pay you when the contract comes due.)

5) Notwithstanding my parenthetical in point 3), debt finance seems to be more common among the plaintiffs' bar than among the defense bar.  But given the high interest rates, one still might wonder why it exists at all.  Wouldn't a better approach be for plaintiff firms to get bigger so that they can self-finance at lower cost?  Yet plaintiff firms tend to be much smaller than defense firms.  Here the answer seems to be that the top of the plaintiff bar does self-finance.  Most of the examples in the story involve tens or hundreds of thousands, not millions of dollars.  But high-end plaintiffs' lawyers can easily self-finance for such cases, and they do--either by themselves or by forming de facto joint ventures with other high-end plaintiffs' lawyers for particular categories of cases.  Because the dollar flow for plaintiffs' work is much less steady than for defense work--which often occurs within a firm that also has other steady work, such as tax, corporate, etc--the joint ventures are temporary, allowing the plaintiffs' lawyers to reduce their overhead in between cases.

Thus, the phenomenon of investor-backed litigation seems to occur somewhere in the middle of the market, not at the top.  Although it's probably true that, per 1), the clients are better off with the debt financing than they'd be without it, they'd be better still if they could go to a plaintiffs' firm that's big enough to amortize its costs across a wider swath of cases.