Third-party funding and litigation crowdfunding: problemi di agenzia
Negli ultimi decenni, sono comparse diverse forme private di finanziamento del contenzioso. Tuttavia, solamente due di queste – il third-party funding ed il litigation crowdfunding – consentono al titolare di un claim, al medesimo tempo, di ripartire i costi e i rischi di un contenzioso. Entrambe queste modalità di finanziamento delle liti presentano specifici problemi di agenzia che, in assenza (ad oggi) di una regolamentazione normativa, vengono affrontati in via contrattuale, con soluzioni che il mercato sta elaborando spontaneamente.
Over the last decades, new private forms of litigation financing have surfaced. Yet, only two of these – third-party funding and litigation crowdfunding – enable a claimholder, at the same time, to share costs and risks associated with litigation. Both these modalities carry specific agency problems which, absent (to date) a law regulation, are being address contractually, through solutions which the market is elaborating spontaneously.
Keywords: Litigation financing, Third-Party Funding, Litigation Crowdfunding, Crowdfunding, International commercial arbitration
1. Addressing costs and risks: the needs underlying litigation finance - 2. Third-Party Funding - 3. TPF and venture capital - 3.1. TPF as a class of venture capital investment - 3.2. Information asymmetries and due diligence - 3.3. Agency problems and investment contracts - 3.3.1. Compensation of funders - 3.3.2. Provision of financing - 3.3.3. Information rights and control over the proceedings - 3.3.4. Exit provisions - 4. TPF and (missing) access to justice - 5. A market-based answer to the call for access to justice: litigation crowdfunding - 5.1. Access to justice for small claimholders - 5.2. LCF and TPF - 5.3. Market-based solutions to LCF’s shortcomings - 6. Conclusion - NOTE
1. Addressing costs and risks: the needs underlying litigation finance
Litigation is costly. Litigants face attorneys’fees, court charges, and expenses for witnesses, investigations and experts. In addition, litigation carries potential costs: in most legal systems the losing party is required to reimburse the expenses in which the counterparty may have incurred for the lawsuit (according to the so-called “English” – or “loser pays” – rule) . Moreover, litigating entails further indirect costs and adverse effects which may be even more relevant . Such disbursements represent an obstacle to justice, as they may dissuade from prosecuting lawsuits. As Jeremy Bentham wrote, justice may be an option «only for those who can afford to throw away one fortune for the chance of recovering another» . Herein lies the reality that the principle of equal justice for all risks remaining merely theoretical . Yet, litigation is also risky since its outcome and subsequent proceeds are by definition uncertain, no matter how strong a case may seem. In essence, litigation may be assimilated to an investment, as a litigant bears certain costs in the hope of an uncertain “profit” . Although every legal system offers numerous solutions (partnerships, companies, hedge contracts, etc.) to spread through the market risks, costs and opportunities associated with ordinary business activities, nothing like that existed for a long time in the litigation field . Over the last decades, a multitude of private, entirely market-based options – all reflecting the conception of claims as objects of property rights, and generally referred to as “alternative litigation finance” (hereinafter, ALF)  – have attempted to fill this void . However, none of these financing schemes – i.e. bank loans , legal insurances , contingency fee agreements , litigation loans  and assignment of claims  – actually enables a plaintiff to avoid paying out of his or her own pockets for legal costs and, simultaneously, to share the risks and opportunities associated with litigation. Over the last years, two new ALF models have surfaced: third party funding (hereinafter, TPF) and, more recently, litigation crowdfunding (hereinafter, LCF). While different in many respects, in both [continua ..]
2. Third-Party Funding
There is no consensus as to how TPF should be defined. Absent a legal definition of TPF, which remains to a large extent not regulated, a variety of definitions has been proposed . In a broad sense, TPF is the provision of financial support to a party involved in litigation proceedings (the funded party) by an entity unrelated to a dispute (generally referred to as “funder”). Under this definition, the notion of TPF may include any kind of financing anyhow related to litigation (such as insurances, loans, etc.). Yet, the most frequent pattern of TPF is characterized by certain additional features. This article intends to focus on this narrower notion of TPF. First and foremost, TPF in the strict sense is a form of “non-recourse financing”. Remuneration is not due save in case of favorable outcome and, in any case, it cannot be higher than the proceeds of the dispute . This circumstance (and the sharing of risk which it implies) qualifies TPF as an investment , rather than a loan . Further, the usage of third party capital is required . Funds have to be granted to cover legal costs , which are borne firsthand by the funder, without any direct cash flow in favor of funded litigants . Moreover, law firms may theoretically enter into a TPF agreement in order to fund a client’s case. Yet, this article considers TPF’s most common model, i.e. when the contract the finance is granted to the litigant party directly . Also, although financing could be offered by and to any entity or person in theory, eligible providers and beneficiaries form quite a restricted circle. As a matter of fact, TPF is traditionally granted by professional, specialized financial entities, which usually pool capital from institutional investors . Similarly, also the pool of eligible recipients is quite restricted, as TPF mainly concerns complex corporations or commercial entities, whose claims are large enough to be worth the thorough preliminary due diligence investigations which TPF-funded cases usually imply and to enhance the chances of high returns for the financiers . This explains why TPF is particularly common in international arbitration, where the sums at stake are generally considerable . Furthermore, although TPF is available to both claimants and defendants in theory, the former happen to [continua ..]
3. TPF and venture capital
3.1. TPF as a class of venture capital investment
Some scholars  stress the analogy between TPF and a very specific class of investments – venture capital (hereinafter, VC), that is the long or medium-term provision of capital by specialized entities (usually financial firms or funds) to early-stage and emerging firms with supposedly high growth potential . TPF and VC are similar in many respects: both TPF funders and venture capitalists are professional players, managing pools of capital which they place on high-risk assets (early-stage companies or judicial suits, as the case may be, having a significant return potential, and an equally high risk of failure); both mitigate such risks through diversification (i.e. developing large portfolios, whose profitability is not measured after a single investment but rather across the global investment batch); neither litigation funders nor VC capitalists aim at acquiring control over the companies or the claims they back; they have similar mid-term investment horizons. Further, potential return stakes are not bought on markets, but rather negotiated with entrepreneurs/claimholders directly, a circumstance which makes both VC and TPF investments illiquid . In a VC transaction, before the investment, investors face certain information asymmetries and uncertainties. For example, startups usually focus on a single product without a proven market potential; success depends almost entirely on the entrepreneurs’individual skills, which are hard to assess in advance (also considering that entrepreneurs – and namely young startuppers – are not in the position to provide entrepreneurial track records); entrepreneurs cannot offer significant collaterals; and they do not own valuable assets, but rather ideas, the quality of which may have been over-stated in order to facilitate the collection of finance . After the investment (i.e. once the entrepreneur gets financed), agency problems arise , such as the risk of an opportunistic conduct by the entrepreneur . In particular, in a post-investment scenario, there is a fundamental misalignment between the entrepreneur’s and the investor’s respective interests: in the essence, the former is inclined to assume more risk and retain the investment longer than he or she would have in a purely self-funded startup; symmetrically, the investor has an [continua ..]
3.2. Information asymmetries and due diligence
In VC, due diligence reviews aim at verifying certain crucial aspects of the business which stands for financing, such as the soundness of the funded startup’s business ideas, its financial statements or the strength of its IP rights . In TPF, such reviews are meant not only to quantify the case’s chances of reaching a favorable decision, but also to assess the concrete possibilities of cashing-in the investment through enforcement. Accordingly, due diligence reviews shall inter alia consider (i) jurisdictional issues (including the risk of bifurcation of proceedings); (ii) strength of the case and availability of evidence; (iii) specific circumstances – either legal (such as the non-accession a the country in which the respondent holds its assets to the 1958 New York Convention) o factual (e.g., respondent’s lack of assets), which may affect the chances to enforce a favorable decision; and (iv) likely duration of proceedings, which directly affects the investment’s profitability. Due diligence process also enables funder to assess proceeds which may realistically be obtained and the necessary budget . The findings of the funder’s due diligence shall be reflected in ad hoc representations and warranties to be released by the funded party and related indemnification obligations . In TPF, it is particularly crucial that the funded party guarantees not to be aware of any circumstance that may give rise to a counterclaim, which would upset the investment scenario and funder’s return prospects. Both in VC and TPF, would-be entrepreneurs/litigants usually grant funders with an exclusivity right throughout the due diligence, so that they cannot accept or solicit any offers by funder’s competitors while due diligence is being carried out. However, while traditional financiers conduct due diligences by examining thousands of documents, deeds, and evidence, technological innovation is changing the scenario. In the US a new Silicon Valley startup – Legalist – is making its way across the US market. Legalist is a TPF financier which runs a web platform , on which plaintiffs can ask for funding. Legalist operates like traditional financiers , except that assessment of cases is conducted by an algorithm , which allows Legalist to reduce due diligence costs and, thus, fund smaller [continua ..]
3.3. Agency problems and investment contracts
Although it is difficult to outline a “model” for VC agreements (which are usually tailored so as to the address the peculiarities of a single case), a number of fundamental and recurrent clauses are utilized in VC practice for the purposes of addressing agency problems, concerning how the funder shall be compensated, as well as how the provision of financing is organized, the degree of control the funder may exert over the business, how cash-flows are to be allocated and, more in general, at what terms the funder may get out of the investment . Such clauses have very close equivalents in typical TPF agreements .
3.3.1. Compensation of funders
Remuneration of funders is a core provision in both TPF and VC agreements. In both TPF and VC, the funder’s compensation corresponds to a given share of proceeds . This structure of compensation is essential to any TPF agreements, which – as anticipated above – qualifies TPF as an investment. Typically, TPF agreements include a so-called “waterfall agreement”, setting forth the order in which all parties – the funder, the funded party and even the lawyers, as long as the latter are on contingent fee – to the TPF agreement are entitled to be paid .
3.3.2. Provision of financing
In both VC and TPF, provisions governing how and when cash-contributions are to be made are of central relevance, as they have the chance, through an economic incentive, to (i) align the funder and the funded party’s interests and (ii) reduce information asymmetries. A common solution in VC is staging investments, through the infusion of capital over time. In particular, after a first contribution, participation of investors to later cash-injections (the so-called “rounds”) depends on the reaching of certain milestones. Should the milestones not be met, the funder may refuse further investments and/or terminate the agreement . Likewise, in TPF financing is usually staged depending on the results of specific procedural steps, such as the completion of the a round of submissions, the outcome of the evidence collection, the results of the hearing of witnesses or the exchange of expert reports . Funder may be granted a right of first refusal on further cash injections, should the results be not satisfactory .
3.3.3. Information rights and control over the proceedings
In VC transactions, on one side the financier aims at controlling what the entrepreneur does; on the other side, no contract may anticipate any possible disagreement between them. So, it is quite common that venture capitalists require to appoint a member of the boards, in order to monitor how the company is run. Moreover, VC contracts usually provide for restrictions for the entrepreneur to depart excessively from the funder-approved business plan. In TPF too, the question poses as to how conciliate the conflicting needs to safeguard the litigant’s autonomy with the funder’s legitimate exigence to be updated about the day-to-day management of the claim and to speak out on most relevant choices. So, typically funders are granted the right to remain constantly informed about the evolution of the proceedings and be consulted before the plaintiff makes any “strategic” decisions, such as accepting or refusing a settlement proposal . Also, TPF agreements usually (i) include a general duty of the funded party to run the claim in a “commercially reasonable manner”, whereby “reasonable” usually corresponds to what appointed counsel suggests; and (ii) provide for the funder’s right to be informed on the litigation or the involvement of financier in the day-to-day management of litigation, by giving advice, helping in reviewing litigation strategies, examine the documents, although without any veto power. TPF agreements may even provide for the funded party’s duty to obtain the approval of (or at least to consult with) the funder before making any “strategic” decisions, such as accepting or refusing a settlement proposal. TPF agreements may provide for “independent assessment” clauses, i.e. that the very final decision is rendered by a qualified third-party (e.g. a renowned attorney). Funders may even require the right to approve the selection of attorneys, whose position is quite similar to that of managers and directors in VC . For the same reasons, lawyers are partially compensated by the funder on a contingent basis, so as to favor a long-term approach and avoid assumption of excessive risks . However, all these kinds of provisions shall be carefully handled, as they may face serious legal restrictions. In most legal systems, an excessively intense control right for funders may [continua ..]
3.3.4. Exit provisions
Whereas in VC investors may exit the investment through the sale of their shares or an IPO of the company, in TPF a settlement or a judgment are needed. However, the investor may need to leave before an arrangement or a final decision are reached – for example, because the suit is turning bad, or is becoming too expensive, or because of discord with the funded party, or because of unpredictable circumstances occur, which change dramatically the reasonable prospects of the investment. Thus, TPF agreements commonly allow for the termination of the agreement in such cases. Sometimes, TPF agreements also allow for the right of the funder to assign the contract to another funder. In all such cases, a sound TPF agreement should specify ex ante which costs shall be borne by the funder. Generally, TPF agreements provide for the funder’s duty to bear all costs incurred up to the termination. It may happen though that, after the funder terminated the agreement, the claimant prosecutes her suit and prevails. It is then advisable that TPF agreements regulates this scenario, by specifying how the proceeds (if any) shall be divided amongst the funder and the funded .
4. TPF and (missing) access to justice
Over the years, TPF has been harshly debated and has attracted severe criticisms, concerning the impact of TPF on (i) the justice system , (ii) the regularity of proceedings , (iii) the funder-plaintiff relationship  and (iv) the lawyer-plaintiff relationship . Most literature advocating for TPF admissibility and legitimacy relies on the fact that (i) TPF agreements are usually entered into by large corporations, which are not in a subordinate position vis-à-vis and therefore do not need any legal protection and (ii) TPF favors safeguards access to justice, enabling impecunious plaintiffs to bring legal actions. While it is not possible to dispute here all charges brought against TPF, most criticisms addressed to TPF, and related calls for regulation, seem groundless. The above being said, the access-to-justice argument is questionable. As a matter of fact, whereas TPF could be accessible to both the rich and the poor in theory, complexity of TPF contracts and preliminary diligence suppose large claims – which are usually held by the rich . Whereas TPF is de facto foreclosed as an ALF option to holders of small claims, technology is offering the latter a solution to financially fuel their legal actions: litigation crowdfunding (hereinafter, LCF).
5. A market-based answer to the call for access to justice: litigation crowdfunding
5.1. Access to justice for small claimholders
Until just a few years ago, anyone who needed money, for whatever reason, had to approach specialized professional figures (banks, funds, financial institutions). Traditional TPF has not changed this paradigm. Yet, technology and the increasingly important role played by the web in our lives developed a solution to avoid traditional intermediaries: crowdfunding – literally, financing by the crowd. Crowdfunding can be defined as the process through which a person publicly raises capital through a large number of modest contributions, in order to find a specific initiative. This request is made through specific online marketplaces (generally referred to as “platforms”), which allow the potential funded (the “fundraiser”) to come into contact directly with potential financiers (the “crowdfunders”) – usually, a large variety of private individuals or, anyway, non-professional lenders – the crowd, literally. Within this definition, a large variety of crowdfunding forms has developed. At its outset, crowdfunding substantially was either donation-based or reward-based. While in the former crowdfunders do not expect any return from their contribution (which, subsequently, qualifies as a donation), in reward-crowdfunding contributors are compensated in kind (with units of the products developed by the funded) or with other forms of reward (such as formal acknowledgement or free entrance to a special event). Later, two further models have made their way on the market: debt-crowdfunding, which allows fundraisers borrow money from the public; and equity-crowdfunding, in which equity for business ventures is raised by entrepreneurs, in exchange for shares of proceeds. People resort to different versions of crowdfunding for various purposes: in order to develop business ideas, to fuel ideal causes, even to fund purely private projects (a marriage, a celebration, etc.). From an economical point of view, equity CF is way the most important version of CF, which has been booming over the last few years. In 2016, the US market – the largest one globally – reached the threshold of $ 34 billions, overtaking the value of VC market . Italian CF market, while way smaller than the US one, is developing quickly too . In September 2018, there were 90 active CF platforms on the whole national territory, a third out of which were CF [continua ..]
5.2. LCF and TPF
LCF’s has strong, evident resemblance to TPF. TPF and LCF meet the same need – sharing costs and risks underlying lawsuits – and in both these ALF instruments financiers are entitled to a share of proceeds, in case the funded action has a favorable outcome. Yet, TPF and LCF are deeply different in structure. First, in LCF – as in every other type of CF – funders are not professional investors, but individual persons usually lacking investment expertise. As a consequence, LCF concerns mostly individuals’(and not only corporations’) claims, which are generally smaller in value. Furthermore, LCF tends to rely on a multitude of contributions by a large group – a crowd – of crowdfunders, whereas in TPF few financiers (or, more often, one only) provide all the money needed for the proceedings. Moreover, while TPF is a bilateral relationship between funder and funded, LCF is triangular, as it involves (a crowd of) funders, a funded party and platform acting as an intermediary between the former two. Structural differences pose both specific informational asymmetries, as well as agency and policy problems – many of which are identical to those already detected in “traditional” CF. First, financiers’possible lack of expertise in the law could lead to poor investments. This is all the more true, as – like in crowdfunding in general – there is not a secondary market for LCF investments, which may help an investor to assess the “right” price for her investment. Further, in CF information asymmetry is extreme. As a matter of fact, CF investors get their information exclusively from online platforms, as they cannot carry out any due diligences or even meet face-to-face the entrepreneur. What is more, such scarce information usually consist of self-produced business plans and valuations. The only information provided by platforms to wannabe-investors tend to be the amount of funds already committed by previous investors. In other words, for an investor considering whether to invest in a case or not, it is impossible to know whether previous investors did invest because they had positive information or just because they followed the herd in turn. As a consequence, risk of a “herding effect” exists: investment campaigns which attracted a higher number of investors from the outset will [continua ..]
5.3. Market-based solutions to LCF’s shortcomings
Whether LCF shall be regulated is not the subject of this article. However, most issues arising from LCF – such as investors’lack of professionalism and information, risk appetite and tendency to herd – concern CF in general and have already posed in relation thereto. Thus, some food for thought may come from the observation of how those issues are being addressed in the “traditional” CF market. In order to address CF’s perils, some commentators have proposed variously interventionist solutions, from mandatory disclosures of relevant information to investors until absolute prohibitions for individual investors to enter into certain types of transactions . Still, such proposals are not convincing. Mandatory disclosures are costly and do not fit to the type of investors targeted by CF, who may reasonably lack the necessary expertise to benefit from them . More restrictive approaches would be likely to thwart the opportunities this instrument carries. In addition, regulation could not be necessary, as platforms are spontaneously trying to address these issues , by leveraging the so-called “wisdom of the crowd”. The idea underlying this concept is that information asymmetries may be reduced if investors are assembled together, thanks to web platforms. After all, platforms have a strong market-incentive to maintain their reputation as a reliable place for people to invest their money . This is evidenced by the fact that some platforms spontaneously act as gatekeepers, implementing strategies to select entrepreneurs which will be granted access to seek investment through them . For example, in order to address the herding-effect risk, platforms allow wannabe-investors to get information not only about the aggregate amount of pledged investment, but also its individual distribution, on the assumption that the higher is the investment committed by a single investor, the more careful the decision to invest was. Some platforms are enabling potential investors to pose questions to fundraisers directly. Other platforms are countering herding-effect by imposing a minimum amount of investment (in the belief that investors will be pushed by the relevance of the investment to carry out some form of due diligence) or limiting access to investors who qualify as “experts”. Further platforms post investment proposals [continua ..]
TPF and LCF may prove extraordinary instruments to guarantee an easier access to justice, for high-stake and small-stake claims respectively. In particular, LCF may potentially revolutionize civil justice, by allowing corporations and individuals and consumers, which are currently excluded from the pool of TPF’s potential users, to share risks and costs of lawsuits with third parties. In TPF, smallness of the circle of its potential users, as well as their typical professionalism and dimensions, enables TPF players to easily arrange any relevant agency problems or information asymmetries through sophisticated financing agreements. This objectively downsize risks and perils allegedly carried by TPF. As regards LCF, it definitely does pose serious questions as regards protection of interests and rights of parties involved, indeed. However, considering that (i) the market is apparently elaborating solutions autonomously and, more in general, that (ii) LCF is still in its infancy, regulators shall be very careful and prudent in intervening. Too an aggressive intervention may be totally unnecessary and, what is worse, deprive LCF of its potential.