Read more about a recent case involving champerty here.

After finding success in the U.K., third-party litigation funding has begun to gain steam in the U.S. The idea is familiar in some contexts: A plaintiff can’t afford to bring, say, a meritorious personal injury claim, so a third party provides a funding source and then takes a percentage of the recovery.

Now, it seems, companies are finding that it may be an opportune time for litigation funding to go mainstream in the business-to-business litigation context, and the emerging hedge fund market promises both opportunities and lingering questions.

“This idea is probably spreading a little faster now due to the stress in the economy,” says Jeffrey Weil, chair of the commercial litigation practice at Cozen O’Connor. “Corporations are stressed and have limited funds to bring litigations. The hedge funds, as they look at the array of possible investment opportunities, have decided that if carefully chosen, litigation is a fairly good investment and that the opportunity for a positive return is better in that venue than it is in a lot of investment venues now.”

Weil says he would be surprised if more than 25 to 30 commercial cases a year used such an external funding source, but the practice is catching on. And litigation funding in general is getting enough attention in the U.S. to draw criticism. In October, the U.S. Chamber’s Institute of Legal Reform released a paper by three lawyers at Skadden, Arps, Slate, Meagher & Flom that urged lawmakers and regulators to “consider prohibiting third-party funding in the United States.” The paper did not focus on funding in a corporate litigation context.

One of the concerns the paper outlined was that the practice will raise ethical concerns. Richard Fields says working through those thorny issues is one reason why the practice has taken so long to make headway in the U.S. Fields, a former lawyer, is CEO of Juridica Investments, a New York-based hedge fund focused on funding large corporate litigation that launched in December 2007. In its first full year in operation, its net assets rose 30 percent, its share price on the London Stock Exchange rose 25 percent, and it paid a 5 percent dividend to shareholders. It’s among the handful of such funds to emerge in recent years, although the economic crash decimated many of them. The insurance company Allianz also has a litigation funding branch, and Credit Suisse has dedicated a division to the practice for a few years now, with former DLA Piper lawyers at the helm.

According to Fields, litigation funding is a concept that the legal and financial industries alike are starting to better understand.

“Figuring out the transactional structures and overlaying that with all the compliance and ethics issues is complex,” Fields concedes. “The bankers haven’t historically understood the legal market, and the lawyers haven’t historically figured out how to access external capital. So what you’re seeing now is really the beginnings of the convergence of law and finance.”

The Free Option

Corporate clients turn to hedge funds like Juridica for many reasons, but one is clear: Large commercial litigation is vastly expensive.

Fields uses the example of a company suing one of its suppliers that recently was criminally convicted of price-fixing–an ideal case for Juridica because the corporate client is the plaintiff in the case and the payoff is likely and sizeable. A company might have a pretty good case to recover, say, $300 million, but undertaking the case could cost the company $50 million for litigation, experts and e-discovery.

But when the company’s GC goes to its CFO with the option to either give legal the $50 million budget or to give the hedge fund 25 percent of the recovery, “The CFO takes the free option every time,” Fields says. “They’d rather have the upside and no downside, and they’d rather spend that money on something else.”

Not all cases are so cut and dried, but clearly the funds have an interest in taking cases they will win. “There’s a fair share of stuff that we reject,” Fields says, noting that usually cases are brought to his attention by law firms, but increasingly corporate counsel are approaching the fund directly. “It’s rare that we take a case that just finds us; we like when we already have a relationship with a client or law firm. We have taken some of those [unsolicited] cases, but it requires trust.”

And the fact that hedge funds must be so choosy may address one of the most obvious complaints about litigation funding.

“If the worry is that this is going to foment frivolous litigation, I suspect that’s not well founded, because the hedge fund investors will evaluate these cases very carefully and would only invest if they thought there was some merit to the case,” Weil says.

Most funds consider cases eligible for financing in situations where the corporation is the plaintiff, such as breach of contract or fraud claims. One corporate area where third-party funding is ahead of the curve is IP litigation. It makes sense: Inventors, often in universities, usually just don’t have the money to fund IP disputes with major corporations.

As to funding a defense, Juridica and others are working on it.

“Most of the talk is about the plaintiff, but in the corporate context there’s certainly some funding and structuring of transactions for the defense,” says Gary Chodes, CEO of Oasis Legal, a fund that focuses on consumer litigation but has taken some commercial cases.

Checking Champerty

Litigation funding comes with a host of compliance concerns, some of which the Chamber’s paper outlined. But Chodes, whom the authors indirectly quoted in their report, cautions that many of the paper’s complaints wouldn’t apply to funding corporate litigation, and Gary Rubin, a co-author of the paper and litigation counsel at Skadden, declined to take a position on the funding of large business-to-business disputes.

Still, ethics and compliance issues remain a major concern in corporate litigation funding, and a good hedge fund will carry out thorough compliance reviews before accepting a case.

Perhaps the first issue to arise will be local laws regarding champerty, the arcane common law doctrine that you can’t buy an interest in someone else’s litigation. Those laws have completely faded for passive (as opposed to interfering) investors in the U.K., where litigation funding is well established, and have mostly faded in the U.S., although some jurisdictions still outlaw it. Others, such as New Jersey, have enacted statutes clarifying that they do not follow the champerty doctrine.

Most recently, the New York Court of Appeals gave a narrow reading of the state’s champerty laws in an Oct. 15 ruling in a case that probed a similar situation but did not involve litigation funding. If a hedge fund were to run afoul of champerty laws, the main issue is that its contract would be rendered void, and therefore it wouldn’t be able to collect, Fields says. Not surprisingly, Juridica gets written opinions from local experts as part of its compliance reviews.

Third-party litigation funding is still largely untested by the courts. Weil suspects that if there were a test case applying champerty laws to third-party litigation funding, U.S. courts might allow the model as they have long approved contingency fee arrangements. Furthermore, he says, the U.S. court system has traditionally kept its doors open to plaintiffs with legitimate grievances.

“I would not be surprised if most courts, as long as the arrangement is structured carefully, would probably be OK with this idea as long as it’s not unconscionable or usurious,” Weil says.

Privilege and Prejudice

Those careful evaluations hedge funds carry out before accepting a case can lead to the next issue–the hedge fund must keep its distance, both to remain a passive investor and to respect attorney-client and work-product privilege.

“There’s an issue created as to whether the client waives work-product by participating in the due diligence process the investors would want before investing money in that case,” Weil says.

There’s also the mandate not to interfere. Fields admits it’s sometimes a challenge to remain hands-off in cases where he has so much at stake, but it’s all part of the set-up.

“What we do is ask clients to keep us informed if some material event happens in the case, and we ask for quarterly reports. A lot of times we work with clients to set up budgets for the case, and sometimes we bring in people to monitor billing guidelines on the client’s behalf,” he says.

As long as litigants keep ahead of ethics and compliance issues, Fields maintains that third-party litigation funding could act as a solution to another of today’s pressing issues: the reconsideration of the traditional, hourly billing law firm.

For in-house counsel and their outside counsel alike, the prevailing debate is how to reshape that inefficient and unpredictable hourly billing system, and Fields says third-party litigation is a tool for litigants interested in reshaping the paradigm. It may be a way to satisfy the demand on corporate counsel to shift risk to their lawyers, which is greater than ever.

“The law firm can’t say yes to every single client that asks to pay on a fixed fee or contingency fee basis,” Fields says. “Not without completely changing their business models, which they don’t have the flexibility to do overnight. So in a way, I like to think we’re a bridge to the future in that respect, that our capital can help realign relationships with law firms.”