Litigation Finance and Economics

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For an investor, litigation funding is too tempting to resist. Litigation funding promises that most elusive of investment returns: ones uncorrelated with an investor’s other investment returns, like those from stocks and bonds and commodities. Litigation funding also invests in a world that seems fraught with possible pricing inefficiencies. It seems plausible — even likely — that a team of smart lawyer-underwriters can identify high-value litigation investments to generate superior returns for litigation-funding investors. But more than a decade of experience suggests that the promise of litigation funding is a siren song. The promise draws investors into the water, but the payoffs may be meagre and rare. While litigation funding has always been controversial with defendants and business trade associations, the real problem is that the investment class is a poor one. First, high-stakes civil litigation is far more complex and random than most investors understand. There are an overwhelming number of ways that litigants can lose and far fewer paths to significant victories. Second, only a subset of good cases — from an investment perspective — is likely to find its way to funders. Third, litigation funding is probably prone to optimism bias, causing litigation funders to overestimate the probability of victory in their cases. Finally, litigation funding is fungible with little value added by the funder, suggesting that competition will drive down any significant profits that have existed in the business previously. While litigation funding serves a valuable social purpose when it allows meritorious cases to proceed that otherwise would not be pursued, we can expect investor success in the field to be rare and likely limited to those funders with the most litigation savvy and the best luck. Nevertheless, investors are unlikely to give up on the space despite the large prospect of poor returns.

Basic economic analysis of litigation funding shows that risk neutral plaintiffs without budget constraints will not accept funding unless they are pessimistic relative to the funder. Risk aversion makes a plaintiff who shares probabilistic beliefs with the funder act observationally equivalent to a pessimistic, risk neutral plaintiff, so she will accept funding as well. An important benefit of litigation funding - evident from the application of a change of measure to risk neutral probabilities, an analytical approach widely used in the pricing of financial derivatives - is that it moves litigation outcomes closer to risk neutral outcomes and therefore closer to actions consistent with the plaintiff's perceived "merits," something that is of underemphasized importance in law and procedure. The best funding outcomes (for investors) are likely when plaintiffs are risk averse or budget constrained. Poor outcomes are more likely when funded plaintiffs are risk neutral and unconstrained.

Chief Judge Posner's 1995 opinion, In the Matter of Rhone-Poulenc Rorer, Inc. has generated considerable concern with settlement pressure on the part of both courts and commentators. This paper cautions against extrapolation of traditional economic analysis of litigation to the problem of settlement pressure. Existing economic models can explain the existence of settlement pressure by relying on notions of defendant risk aversion. But risk aversion is a concept appropriate to explain the behavior of natural persons, not the large public corporations that face class action settlement pressure in the real world. Deeper insights into complex civil litigation involving corporations require taking more seriously what we know (and do not know) about corporate - not individual - behavior and decision-making.

It has long been understood that risk aversion reduces the likelihood of suit. This article offers a simple proof that risk aversion is observationally equivalent to risk-neutral pessimism by applying a change of measure to risk-neutral probabilities. The observational equivalence of risk aversion to risk-neutral pessimism may provide a useful framework for proving results in the study of several areas of interest, including (1) the role of risk-transfer mechanisms like contingency fees and litigation funding; (2) calls for prohibitions on, or judicial participation in, plea bargains; and (3) broader judicial review of the fairness, reasonableness, and adequacy of settlements in individual (that is, non-class) civil actions.

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