When Bloomberg Law recently previewed its top six litigation issues for 2024, five were probably familiar: abortion, administrative law, antitrust enforcement, transgender rights, and opioids.

But the sixth might have surprised you: litigation finance.[1]

It’s a sign of how important third-party finance has become in an era when commercial cases can cost many millions of dollars and billing rates are expected to rise by 6 percent to 8 percent at major law firms in the coming year.[2]

While many commentators support litigation funding, some oppose the practice of third parties providing capital to litigants or lawyers in exchange for a right to some proceeds from the litigation. One of the principal objections is that the introduction of a third-party funder might interfere with the attorney-client relationship. “Third party financing weakens the traditional attorney-client relationship,” the U.S. Chamber of Commerce Institute for Legal Reform claims, raising “serious questions concerning the funder’s place in that relationship.”[3]

In a new  article, however, we argue that critics have it backwards: The hybrid fee arrangements that funders typically insist upon actually better align lawyer and client than the hourly or contingency fees that litigants typically pay their lawyers.[4]

Hybrid Fee Arrangements

The hourly fee – where the lawyer is paid for the time she spends on  the case, without regard to whether the case succeeds – renders the lawyer completely indifferent to the magnitude of the client’s recovery and adverse to the client on the speed with which that recovery comes. The longer it takes for the case to resolve, the more hours the lawyer bills, and the more she gets paid.

With the contingency fee, the lawyer is not indifferent to the size of recovery, as the lawyer’s compensation is based on a percentage of the case proceeds. The larger the damages, the greater the lawyer’s compensation. But the lawyer is still adverse to the client on speed, just in the opposite direction: the lawyer wants to settle too quickly because the lawyer must bear all the effort of going forward with the litigation while collecting only a fraction of the return on effort; this gives the lawyer an incentive to settle prematurely even if it means a smaller recovery.

When a case is financed by a third-party , the lawyer usually does not work on a pure hourly fee or contingency fee. Rather, the litigation funder typically requires a hybrid fee that contains features of both the hourly and contingency fees.

Funders typically pay only a portion of a lawyer’s hourly fees – say, 50 percent — and further provide the law firm with a moderate contingency fee in the case. That is, the lawyer is usually compensated in two different ways: partly on an hourly fee, where the firm receives only a percentage of its normal billable rate, and partly on a contingency fee, where the firm receives a portion of case proceeds if the case succeeds.

Better Aligning Lawyer and Client

Why do litigation funders seek these hybrid fee arrangements?

Litigation funders invest in cases, but the legal ethics rules prohibit them from controlling those cases. Financiers are thus careful to structure everyone’s payouts to ensure that neither the lawyer nor the litigant can take advantage of the financier, by, for example, in the case of the litigant, accepting a settlement offer that would be unfavorable to the financier or refusing a settlement offer that would be favorable to the financier, or, in the case of the lawyer, by shirking or overbilling.

To prevent this, the financier attempts to align its interests with each of these other parties as closely as possible.

The hybrid formula is the product of this drive to align incentives in the absence of the ability to control the litigation. Financiers do not want to pay all a lawyer’s fees (even as capped by the anticipated budget) to ensure that the lawyer will have a strong incentive to efficiently litigate the case; the incentive to drag out litigation is a principal drawback of the hourly fee.

At the same time, financiers want lawyers to have skin in the game to ensure they have the incentive to maximize the case’s value and, in turn, in at least some of the examples, the financier’s return on investment. Thus, the financier insists the lawyer take a contingency percentage in the case as well.

Reduced Agency Costs

Scholars have long recognized that the hourly and contingent fee models raise significant agency costs. And scholars have previously argued that there is a better way: a hybrid formula.

In an underappreciated article written 45 years ago, Kevin Clermont and John Currivan showed that a hybrid formula where the lawyer collects an hourly fee in addition to a contingent percentage almost always reduces agency costs compared with either hourly fees or contingent percentages alone. This formula pits the hourly fees and contingent percentages against one another to improve upon them both: The percentage component of the formula gives the lawyer an incentive to care about the magnitude and speed of the recovery while the hourly component mitigates the incentive to settle prematurely.

The hybrid formula Clermont and Currivan studied was different than the one used by third-party financiers: Their formula made even the hourly fees contingent on some recovery by the client. Subsequent scholars have shown that the hybrid formula with non-contingent hourly fees is even better than the one studied by Clermont and Currivan – indeed, if the hourly fees are paid by a third party and set correctly, it can actually perfectly align the lawyer’s incentives with the client’s interests.

In other words, hybrid fee formulas similar to those presented in litigation finance deals likely better align the incentives of the lawyer and client than does a pure hourly or contingent fee!

Conclusion

We think critics have gotten backwards the agency-cost story of third-party litigation finance. Rather than exacerbate agency costs by illegally meddling with the lawyer-client relationships, because it is so difficult to legally meddle in the litigation, financiers protect themselves instead by trying to align their interests with the lawyer and the litigant. The happy and predictable side effect of these efforts is that they end up better aligning the lawyer and litigant with each other, too.

Churchill said democracy is “the worst form of Government except for all those other forms that have been tried.” Litigation finance may not be perfect, but it is better than the hourly and contingency fee, at least when it comes to aligning the incentives of lawyer and client.

ENDNOTES

[1] Bloomberg Law 2024:Litigation, https://pro.bloomberglaw.com/bloomberg-law-2024/#litigation.

[2] Zack Needles, Big Law’s Approach to Billing Rate Hikes in 2024: The Morning Minute, Nov. 1, 2023, https://www.law.com/2023/11/01/big-laws-approach-to-billing-rate-hikes-in-2024-the-morning-minute/#:~:text=The%20rate%20increases%20will%20vary,between%206%25%20and%208%25.

[3] U.S. Chamber Institute for Legal Reform, Third Party Financing: Ethical & Legal Ramifications in Collective Actions at 3 (2009), https://instituteforlegalreform.com/wp-content/uploads/2020/10/Third_Party_Financing.pdf.

[4] Brian Fitzpatrick & William Marra, Agency Costs in Third-Party Litigation Finance Reconsidered, Vanderbilt Law Research Paper No. 23-45, https://ssrn.com/abstract=4649666.

This post comes to us from Professor Brian T. Fitzpatrick at Vanderbilt Law School and William Marra at Certum Group. It is based on their recent article, “Agency Costs in Third-Party Litigation Finance Reconsidered,” available here.