Why Are Hedge Funds Allowed to Invest in Litigation?

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A justice system can't really be impartial when there are business entities betting on it.

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When we think of our system of justice, we might envision the heroic small town lawyer, Atticus Finch, in To Kill a Mockingbird. Or the jury deliberations in 12 Angry Men. Or the countless other movies, TV series, and high school civics textbooks that depict the U.S. justice system as a uniquely virtuous pillar of American society.

Unfortunately, that glorified image of the U.S. justice system is at odds with today's reality. In far too many instances, today's civil justice system is utilized not as a means for delivering justice but as a potential profit center -- in other words, less Atticus Finch and more Gordon Gekko, the rapacious investor in Oliver Stone's Wall Street.

We see this play out in some class action lawsuits, where the class members receive token awards while their lawyers walk away with millions. It is also visible in the millions of dollars spent every year by the plaintiffs' bar on advertising, a practice once prohibited for lawyers.

And this troubling trend could be accelerated by a new development: the spread of third-party litigation financing, or TPLF.

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You probably haven't heard of TPLF. It's a fairly recent creation, originating in Australia and now landing on the shores of the U.S. In essence, TPLF is the practice of hedge funds and other investment firms providing funds to plaintiffs' lawyers in order to conduct litigation. If the case is won in court or settled, the investor is repaid out of the proceeds of the lawsuit, usually with an extremely high rate of return. The investors, therefore, have a direct stake in the outcome of the case.

Proponents of TPLF say that providing this new funding stream increases access to the courts. But U.S. courts are already widely accessible. For instance, a plaintiff can hire an attorney on a contingency fee basis, a practice that is prohibited in most other developed countries.

While TPLF is not necessary to increase access to U.S. courts, it does create a whole new set of problems and conflicts of interest for litigants, their attorneys, and society at large.

Let's start with the litigants. TPLF supporters allege that the practice is risk-free for plaintiffs, since, if they lose, they typically don't have to repay the investor. But more than 95 percent of U.S. civil cases end in settlements rather than going to trial. And a closer look at one recent case demonstrates major dangers for plaintiffs if they accept a settlement that's less than that demanded by the investor.

In this case, a Texas-based security company, DeepNines, obtained an $8 million loan from a TPLF firm to fund patent litigation against a competitor. In the end, DeepNines received a $25 million settlement. However, because of the terms of the TPLF contract, the investor received $10.1 million of the settlement, while DeepNines, after paying attorneys' fees, netted less than $800,000 -- only about 3 percent of the total settlement amount.

To add insult to injury, the investor then turned around and sued DeepNines for settling for an amount below what the investor's financial models suggested they could receive. The case was eventually resolved through a confidential settlement.

Like Gordon Gekko's insider trading machinations, the DeepNines example shows that many TPLF contracts are rigged in favor of investors. For instance, the contracts often provide for "waterfall" payouts -- meaning that the TPLF investors take a higher percentage of the first dollars of settlement, while the plaintiff's share only rises as the total settlement figure reaches an amount pre-set by the investors. Thus, plaintiffs are pressured to hold out for settlements or judgments far above what they would have accepted otherwise in order to satisfy their investors. And defendants suffer as well, since they are forced to contend with longer and costlier litigation. This scenario stands the justice system on its head by putting the investor in the driver's seat while hurting the primary parties in the case.

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Presented by

Lisa Rickard

Lisa A. Rickard is president of the U.S. Chamber Institute for Legal Reform, president of Workforce Freedom Initiative, and executive vice president of the U.S. Chamber of Commerce.

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