Third Party Litigation Funding Enters the Professional Liability Space
This article is a follow up to our June 8, 2015 article, You Can’t Handle the Suit, which addressed the emergence of third-party litigation funders (“TPLFs”) and their potential impact on litigation costs and the insurance industry. As discussed in You Can’t Handle the Suit, TPLFs finance litigation costs upfront in return for a percentage of the proceeds from the litigation, if successful.[i] While TPLFs were not a novelty even in 2015, the industry has since “blossomed into a massive industry.”[ii] TPLFs first emerged in personal injury actions and provided a means to allow a plaintiff to “have their day in court.”[iii] However, a large number of TPLFs no longer provide funding for personal injury actions. Instead, TPLFs have turned their focus towards commercial litigation actions and class actions in seeking out a much larger recovery.[iv]
What was once described as an industry focused on assisting the Davids against the Goliaths, third party funding has rapidly expanded and as a result, TPLFs have driven litigation costs and awards and settlements up.[v] This phenomenon is somewhat difficult to understand as TPLFs often hide in the background and defendants may not even be aware that they are involved in a case. However, we have seen that TPLFs have become more active in the Professional Liability space, and that will impact those professionals and the Underwriters who insure them.
How TPLFs operate
Briefly, TPLFs generally agree to fund litigation costs and expenses with no guarantee that they will receive a return on their investment.[vi] Interestingly, most TPLFs are started or controlled by litigators.[vii] Prior to investing in a case, TPLFs must, among other things, weigh the costs of litigation against the expected award or settlement. Ultimately, any proceeds are used to pay some or all of attorneys’ fees and costs first, and then TPLFs take a large portion of the recovery, often leaving the plaintiff with less than half of the settlement or award.[viii] At the same time, some of these cases would never have been brought but for the TPLF as a plaintiffs’ attorney might not be willing to assume all the risk of taking the case. Thus, TPLFs assumption of the litigation risk generally increases the amount of litigation.
Given the risk of an adverse award or unfavorable settlement, TPLFs charge excessively high interest rates. While these rates and agreements are normally non-public, the New York Post reports that one TPLF regularly charges clients an interest rate of 124%.[ix]
TPLFs Driving “Social Inflation”
The term “social inflation” has been used to describe the rising costs of insurance claims due to a number of non-claim specific factors.[x] Rising costs both in settlement and defense are attributable to a number of factors including, but not limited to, increased litigation costs and larger jury awards and settlements.[xi]
According to Bloomberg, as of 2022, the TPLF industry is estimated to be worth $39 billion worldwide.[xii] TPLFs such as Burford Capital are publicly traded on the stock market, and college endowments have even taken shares in the TPLFs.[xiii] Thus, TPLFs have “gone mainstream”, and there is no indication that the TPLF wave is anywhere near an ebb tide.
While there are risks inherent in litigation funding, according to a report by Swiss Re, internal rates of return on litigation funds is up 25% in recent years.[xiv] Further, despite the negative impacts of the COVID-19 pandemic, roughly $2.5 billion was invested into TPLFs in 2020, and investments grew by 16% in 2021.[xv] TPLFs are so prevalent today, they often advocate in front of legislature and bar organizations and now have their own trade lobby, the American Legal Finance Association (“ALFA”).[xvi]
Due to the rapid growth of TPLFs, and their increased involvement in litigation, some cases are taking a year longer to resolve than they would if a TPLF was not involved in the case. But, the additional time spent litigating the case is not necessarily producing a benefit to funded parties (i.e., higher recoveries).[xvii] One reason, as discussed, is that litigants who engage TPLFs usually see a return of less than half of the award or settlement amount. Further, per a Swiss Re report, TPLFs appear to cause an increase in large claims and thus are reducing insurability.[xviii]
The simple addition of another party in litigation with decision making power over a settlement increases the likelihood that a case will not settle, especially early in litigation. For example, a plaintiffs’ attorney on contingency might want to put minimal effort into a case in order to limit costs and maximize recovery, but if a TPLF is paying his or her bills, then there is no such pressure for an early settlement.
So what does this mean for the insurance industry? The involvement of TPLFs in lawsuits provides injured parties with resources to match insurance companies. As such, plaintiffs can now prolong litigation which leads to additional costs and larger awards if the case gets past dispositive motions and close to a jury.[xix] Ultimately, the insurers may be forced to pay out higher claims or increased defense costs to defend a case longer. However, as the claims increase in cost, so do insurance premiums and therefore policyholders are forced to also bear the brunt of the cost.[xx] TPLFs therefore have a significant effect on how risks are underwritten in insurance policies.[xxi] Insurers must now adjust to the presence of TPLFs and this will require them to take into account potential “nuclear verdicts” when assuming liability risks.[xxii]
Professional Liability Litigation Involving TPLFs
TPLFs are affecting certain areas of insurance more than others. For example, according to a 2020 study by the American Transportation Research Institute, the average trucking lawsuit verdict grew by $20 million dollars between 2010 and 2018.[xxiii] The study found that these increased verdicts “far exceeded standard inflation and health-care cost increases.”[xxiv] In order to adjust for the increased verdicts, insurers in the trucking industry have significantly increased annual premiums and some companies have even withdrawn from the market altogether.[xxv]
While it does not presently appear that TPLFs are funding professional liability lawsuits, certain cases are addressing the role of TPLFs in connection with professional liability claims. In Tradeline Enterprises Pvt., Ltd. v. Jess Smith & Sons Cotton LLC, before the United States District Court for the Central District of California, the court addresses a TPLFs potential liability in the underlying action.[xxvi] In this case, the plaintiff filed various antirust claims against the defendant and used a TPLF to fund the litigation.[xxvii] The defendant counterclaimed for breach of contract and theft and ultimately an $8.9 million arbitration award was entered in defendant’s favor. [xxviii] However, it being apparent that the plaintiff could not cover the award, the defendant moved to seek the identity of the TPLF and to enter judgment against the TPLF.[xxix] The defendant argued that the TPLF would have reaped the benefits of a large award in plaintiff’s favor and therefore, it should be responsible for the consequences of the plaintiff losing.[xxx]
Further, TPLFs are suing attorneys whom they have retained in connection with litigations they are financing.[xxxi] In the United Kingdom, a TPLF sued a firm it hired to perform due diligence on a lawsuit the TPLF was funding in South Africa.[xxxii] The firm argued that it was not negligent in its performance of due diligence and that the TPLF is not entitled to damages unless the underlying action is resolved in the plaintiff’s favor. This case raises a serious concern regarding whether a firm could be liable to both its client as well as a TPLF for its role in encouraging funding of a particular matter. Thus, simply by expanding the amount of litigation in the courts, TPLFs are also increasing the risk to attorneys who bring claims on behalf of TPLFs.
Thus far, we have seen a handful of cases where TPLFs are involved involving professional liability. These TPLFs have made it more difficult to settle cases, and it also complicates settlement discussions when a court or ADR panel orders parties to mediate with all decisionmakers present. We have already seen cases where a defendant professional firm engages in good faith settlement discussions and gets close to a settlement when opposing counsel drops the news that the TPLF that is not present or reachable must also approve of the settlement. These situations complicate any resolution effort and make pre-trial resolution more perilous.
It seems that it is only a matter of time until TPLFs break full time into funding professional liability cases. If this does occur, the professional liability insurance industry could face a similar fate to that of the trucking industry. The good news is that professional liability insurers can learn from the woes of insurers in the trucking industry and take into account the negative impacts of TPLFs during the underwriting process. At the same time, those professionals, specifically lawyers and accountants, must also reckon with the possibility of TPLFs putting their entire business at risk when dealing with their own clients. This is not typically what these professionals consider when taking on an engagement, but the risk is there.
Proposed Regulation of TPLFs
While some argue that TPLFs are a positive resource for litigants, it is clear that they raise issues, even outside of their impact on social inflation. Given the ability of TPLFs to extend the life of a case, TPLFs may raise ethical and conflict concerns.[xxxiii] Specifically, the concern is that firms may continue to pursue an action contrary to the client’s best interest because they must also take into account a TPLFs return.[xxxiv] Further, given the increased likelihood of “nuclear judgments” TPLFs may unjustly enrich nonparty investors instead of merely making the injured party whole.[xxxv]
TPLFs can also cause conflict of interest issues because the majority of venues do not require the disclosure of TPLFs.[xxxvi] To eliminate this issue, some courts such as the U.S. District Court of New Jersey have held that TPLF agreements must be disclosed during litigation.[xxxvii] A federal court in California held similarly, and Wisconsin and West Virginia have both passed legislation which requires disclosure. To date, however, there has been no federal legislation which would require such disclosure, and none on the horizon.[xxxviii]
Jack Kelly, the managing director of the ALFA has recognized that some TPLFs are not well respected.[xxxix] As such, Kelly believes that legislation is necessary to limit fees, prevent kickbacks and restrict TPLFs from any involvement in the underlying litigations. Notably, New York State has introduced a bill in 2021 which, if approved, would regulate TPLFs in a manner consistent with Kelly’s concerns. The bill would, among other things, place a cap on the interest rate a TPLF can assess (36%), prevent plaintiffs’ attorneys from collecting a referral fee, restrict TPLFs from having any control over the litigation, and protect all communications under the attorney-client and work product doctrines.[xl] The bill is still in its infancy, however, as it is under committee review, and it will only be put on the calendar for a vote if the committee releases the bill.
TPLFs have continued to grow at a significant rate, which has already had an effect on the insurance industry as litigation becomes not just a way to resolve disputes but a way for investors to profit. Based on the above referenced proposed regulations and court orders, it is clear that the effect of TPLFs has not gone unnoticed. Some of these proposed regulations may benefit insurers. For example, disclosure of the involvement of a TPLF in a case could help streamline potential settlement discussions would completely eliminate any conflict-of-interest issues. Additionally, if TPLFs lacked control over the litigation, cases may not extend for as long and thus litigation costs and awards or settlements may decrease.
Professional liability insurers must continue to keep tabs on TPLFs and their potential impact on claims. While TPLFs have not yet broken into this market in a significant known way, insurers should learn from the industries that have already been greatly impacted by the ability of TPLFs to contribute to social inflation and increase the cost of defending and resolving claims.
 The issues of increased claims and defense costs raises an interesting point of how contracted for policy limits may not cover these increased awards. While many large policy holders also obtain excess coverage, it remains to be seen whether even excess coverage will be sufficient.
[xv] https://www.natlawreview.com/article/litigation-funding-may-soon-be-addressed-new-york-s-legislature; https://www.insurancebusinessmag.com/us/news/commercial-auto/us-litigation-funding-impacting-costs-of-liability-claims-326725.aspx