Remember when ALF was a furry puppet on TV who ate cats? Simpler times.
Now ALF refers to Alternative Legal Funding, the burgeoning new terrain of third-party investment in litigation. The tactic is exploding on the legal scene: one poll estimates that 28% of all law firms used ALF in 2015, which is four times as many as 2013. Investors hunting down new markets are normalizing the practice into a billion-dollar industry.
But these financial arrangements are new, largely unregulated, and constantly shifting. There aren’t clear nation-wide guidelines to follow, and many jurisdictions are in the process of changing their stances. The upshot is that attorneys caught in the middle of ALF agreements may find themselves disoriented and uncertain of their ethical duties.
But despite all this flux and uncertainty, attorneys can’t sit waiting for the dust to settle before engaging with the question of lawsuit investments. The ABA asserts that attorneys have the duty to
“become fully informed about the legal risks and benefits of these transactions, in order to provide competent advice to clients. Because this is a new and highly specialized area of finance, it may be necessary for a lawyer to undertake additional study or associate with experienced counsel when advising clients who are entering into these transactions.”
The ALF show might have died with the 80s, but Alternative Legal Financing is only becoming more popular. So here’s a brief history to set the stage for modern third-party legal investments, and recent scholarship six areas of special ethical concern.
Champerty: from Medieval Bribery to Modern Free Speech
‘Champerty’ sounds like a shampoo brand, but it’s actually an ancient legal doctrine related to third-parties supporting lawsuits and then divvying up the spoils.
Go back a few centuries and you’ll find the courts spitting out this word like an epithet. Champerty is from a French term for share-cropping out a field, but to the judges of medieval England it meant a plague of frivolous lawsuits. As quoted by an ABA working group on ALF: The wealthy and powerful would “buy up claims, and, by means of their exalted and influential positions, overawe the courts, secure unjust and unmerited judgments, and oppress those against whom their anger might be directed.” Also, “barons abused the law to their own ends and . . . bribery, corruption, and intimidation of judges and justices of the peace was widespread.”
Accordingly, the courts outlawed champerty for centuries, and called it a win for justice.
But then times changed and something happened: a series of modern legal reforms and ethics rules came into place with power to push back against the abuses seen in champerty. By the early 1800s, British philosopher Jeremy Bentham was reminiscing about those barbarous times when “a man would buy a weak claim, in hopes that power might convert it into a strong one, and that the sword of a baron, stalking into court with a rabble of retainers at his heels, might strike terror into the eyes of a judge upon the bench.”
Then Bentham celebrates: “At present, what cares an English judge for the swords of a hundred barons? Neither fearing nor hoping, hating nor loving, the judge of our days is ready with equal phlegm to administer, upon all occasions, that system, whatever it be, of justice or injustice, which the law has put into his hands.”
All this ‘equal phlegm’ was a triumph of the rule of law (doctrines of abuse of process, malicious prosecution, wrongful initiation of litigation, etc.), and it meant the anti-champerty team lost its vitriol and its reason for being.
What’s more, some began to make the argument that third-party legal investment could make the legal system more fair. As attorney Stephen E. Embry writes:
“Historically, well-heeled parties had certain and inevitable advantages in litigation. They could hire the best lawyers and experts, and then grind the less well-off party into submission both because of a lack of resources and cash flow issues.”
The U.S. has since joined several other countries in allowing third-party funding. In the notable 1961 U.S. Supreme Court case NAACP v. Button, the state of Virginia defended its legal ethics laws against champerty, passed to selectively stymie lawsuits from the NAACP, which the State saw as frivolously ‘stirring up’ school desegregation lawsuits. The Court determined that the NAACP’s free speech and assembly rights, enacted in their freedom to litigate, took precedence over the State’s desire to regulate professional misconduct.
In the uneasy interplay between money and justice, it’s easy to make the case that plaintiffs’ access to third-party funding makes the playing field (in Embry’s elegant terms) “if not leveled, at least tilted more toward plumb.”
The Tilt Toward Plumb: Modern ALF
What does ALF look like now? A lot of different things—which makes it nearly impossible to establish generic ethics rules. ALF can mean multi-million-dollar investments made by financial giants for sophisticated commercial and patent litigation; or it can mean college kids up against a wealthy institution crowd-sourcing their filing fees.
But researchers can see some general trends: ALF is most often used by plaintiffs in personal injury cases or commercial or consumer civil litigation. The ABA found that personal injury plaintiffs often turned to ALF to cover living expenses during the litigation process:
“Injured plaintiffs are often disabled or at least unable to work at their previous job, and may lack access to conventional sources of capital, such as bank loans and credit cards. They may therefore have a pressing need to make mortgage or rent payments, or to pay medical expenses.”
The funders (often referred to as “suppliers”), in turn seek out a return on their investment, either through interest earned over the life of the loan, a multiple of the advance amount, or a percentage of the settlement or judgment the client reaches. Typically this is a ‘non-recourse’ debt, meaning the supplier only looks to possibilities of settlement or judgment to get their repayment—though in some cases it’s possible for clients to offer additional collateral to suppliers to get the funds they need.
It’s a further complication of paperwork and ethical tangles, but at the end of the day, many argue the arrangement increases access to justice, as those without the bucks to fund their own lawsuits—and attorneys unable to take on major financial risk—can get financial backing for their cases.
About Those Ethical Tangles:
The general public’s introduction to ALF probably came through Hulk Hogan’s sex tapes. When the professional wrestler sued Gawker for publishing his private film, he won a judgment that completely destroyed the snarky media outlet. The story grew juicier when a secret third-party funder was discovered: Peter Thiel, a Silicon Valley billionaire bearing a grudge (Gawker outed him as a gay man years before).
While the outside world woke up to the big ethical questions behind Thiel’s move, the legal ethics scholars had already been hard at work for years to establish some parameters for third-party legal funding. Due to the rapid expansion of the ALF market, the lack of regulations or suppliers’ fiduciary duties to clients, and wobbly changes in statutes and case law, scholars and bar associations are still better at pointing out regions of controversy than offering concrete guidelines. But most agree there are several key areas where attorneys should be careful.
Here are six that are frequently cited:
- Check local statutes and caselaw:
The first big warning is that there aren’t broad and clear rules about this. When it comes to third-party lawsuit investments, statutes and case law vary widely across jurisdictions. Two states (Illinois and Mississippi) ban the practice outright. A recent survey found at least 27 jurisdictions which explicitly permit some kind of champerty under three conditions:
- It may not be used to promote ‘frivolous’ lawsuits.
- Suppliers may not engage in ‘malice champerty’ — litigating with an improper motive.
- Suppliers may not ‘intermeddle’ with the conduct of litigation (such as trying to control trial strategy or settlement amount)
As with many new and developing legal issues, acceptance of this financial technology will happen incompletely and unevenly: national guidelines can’t take the place of familiarity with local rules.
- Avoid Financial Stake in the AFL:
The ABA Working Group on Alternative Litigation Finance pays special attention to Model Professional Conduct Rule 1.8(i). This conflict of interest rule establishes that lawyers “shall not acquire a proprietary interest in the cause of action or subject matter of litigation the lawyer is conducting for a client.” The only exceptions are contingency fees and legally authorized liens for lawyers’ fees and expenses.
This means that the attorney can typically assist their clients in getting third-party funds, but can’t themselves benefit financially from it. Further financial stake in the outcome could “materially impair the lawyer’s ability to consider alternative courses of action that otherwise would be available to a client, to discuss all relevant aspects of the subject matter of the representation with the client, or otherwise to provide effective representation to the client.”
Be especially careful when referring clients to suppliers. Most state ethics opinions on the subject state that it’s permissible for attorneys to inform their clients of the availability of third-party funding and refer them to suppliers, but the waters get murkier if you receive a referral fee for doing this. Some state ethics rules outright prohibit referral fees—but even where it is permitted, disclose to the client that you get the fee and first receive the client’s informed consent.
If you consistently work with the same supplier, you should also let your client know about your relationship, whether you get a referral fee or not.
And in general, the ABA working group warns attorneys to be certain they don’t have an ownership interest in the supplier they refer the client to; are satisfied that the funding arrangement is in the client’s best interest; and avoid situations where their professional judgment could be compromised by third-party interests.
One reason courts don’t want attorneys to be lending additional money to their clients is because this would make it more difficult for the client to end the representation relationship if they are dissatisfied. The client’s right to fire their lawyer is nearly sacrosanct. This issue could also arise if the supplier tries to include rules about the client not changing their attorney without the supplier’s consent. The validity of a contract restricting a client’s rights like this depends on jurisdiction and state statutes.
- Safeguard Your Professional Judgment
Some ALF suppliers play an entirely passive role in the lawsuit process, never weighing in on legal strategy. Others may be inclined to meddle. In order to protect their investment, suppliers could try to exercise control in the lawsuit: determining who the plaintiff’s legal team will be, asserting what kind of litigation strategy they should use, and agitating for final say on whether to accept or refuse a settlement offer.
All of this could violate Model Rule 5.4(c), which asserts the necessity of the lawyer’s independent professional judgment. Attorneys faced with these kinds of restrictions should seriously consider whether it’s possible for them to provide competent representation to their client in these settings.
The ABA found that contracts between potential clients and their ALF suppliers might so dramatically constrain your ability to represent the client that you can’t take their case. As an example, they cite a provision which allows the supplier to refuse further funding if the attorney makes decisions they don’t like. While some jurisdictions prohibit other parties taking over decision-making power from the client, others might prioritize contract law, asserting a client can willingly give the supplier the right to make major decision. The ABA working group calls this entire field “a significant open question.”
Even if the supplier stays passive in the case, you should still watch out for “implicit interference,” especially in the client’s incentives to settle or go to trial. Settlements that would otherwise benefit your client may be too small to tempt them after they pay their contingency fee and their lender. Alternatively, they may feel over-pressured to settle early in order not to rack up higher interest on the loan given to them. But, the ABA notes, in this respect “the presence of ALF is not different in kind from the other factors that are part of virtually any decision to settle; thus, they do not present distinctive ethical issues, beyond the duty of competence and the client’s authority to make settlement decisions.”
- Keep Secrets
In an eagerness to protect their investment, a supplier may try to wheedle out of an attorney all the details of the case. The ABA working group asserts “lawyers must be vigilant to prevent disclosure of information protected by Model Rule 1.6(a), and to use reasonable care to safeguard against waiver of the attorney-client privilege.” They point to three overlapping yet distinct confidentiality doctrines: 1) duty of confidentiality; 2) evidentiary attorney-client privilege; 3) the work-product doctrine.
The duty of confidentiality is much broader than attorney-client privilege, which only protects communication made in confidence between the attorney and client for the purpose of obtaining legal assistance. But in sharing any confidential information, or even non-confidential information, you should first get your client’s consent.
In addition to being an ethical breach in itself, keep in mind that privileged information given to funders could later be discoverable.
- Keep Fees Reasonable
In some situations, attorneys themselves take out loans for lawsuits, and then pass on borrowing costs to their clients. Some commentators are concerned that this is all a covert way for attorneys to up their contingency fees by adding in extra costs to clients. The ABA working group notes that though it’s generally permissible for lawyers to pass on borrowing costs to attorneys, there are stipulations: 1) the conditions need to be clearly disclosed to the client, including the question of whether the expenses are deducted from the recovery, and whether this deduction happens before or after the lawyer’s fee is calculated; 2) the interest rate must be reasonable; 3) and the lawyer should not add a surcharge to the disbursements or charge the client for “general overhead expenses.”
All representation fees, including contingency fees and borrowing costs passed on to the client have to pass the ‘reasonableness’ test set up in Rule 1.5(a).
- Advise Your Client
Though some attorneys may be averse to diving into the ethical nitty-gritty of alternative legal financing, the ABA working group asserts they have a duty to advise their clients on these transactions: “If the lawyer is unfamiliar with transactions of this nature, he or she must either acquire the appropriate knowledge through reasonable study and preparation, associate with an experienced lawyer, or refer the client to another lawyer with established competence.”
The counsel offered by competent attorneys on this issue should touch on what kind of control the supplier is seeking and how that could affect the client’s case, whether the supplier wants access to confidential information, and the basic material terms of the contract.
Some clients might enter into ALF agreements before they ever see a lawyer. If this happens and a lawyer later finds the terms of the agreement to be substantively unfair and unreasonable, they may encourage the client to attempt to renegotiate the terms of the agreement. This could happen if the supplier, operating on a non-recourse basis, charges unreasonable interest rates based on an extreme risk assessment.
High interest rates on these loans at times raise the question of whether suppliers are violating usury laws. Suppliers sidestep these laws by arguing they aren’t issuing a loan, since they won’t recover any funds if the settlement is small or the judgment goes against them. Instead, they claim they are making an investment or purchasing a share of a claim.
In several states (Maine, Nebraska, Ohio, and Oklahoma), there are further statutes in place against predatory consumer litigation lending, in addition to usury laws.
This is only a brief introduction to some of the thorny issues attorneys are facing as they navigate these new waters. Are the legal tangles worth it? As Stephen Embry notes:
“Balanced against the risks is the upside. In a world where over 60% of small businesses who experienced a legal event in the past two years report not hiring a lawyer (LegalShield Survey Report ), where 80% of the legal needs of the poor and middle class go unmet (See Legal Service Report)and where some 40% of law school graduates can’t find full time jobs (ABA 2015 Report) anything that tears down barriers to justice and allows an underserved population to be served may be worth the risk.
“And like many technological enabled disruptions, this one is here to stay.”