When the U.S. District Court for the Northern District of California became the first federal court in the nation to set down transparency requirements for litigation funding, it focused on a particular segment of the industry: class actions. The major funders such as Burford Capital and Bentham IMF reacted with a shrug, saying that class actions are a small or nonexistent part of their business.
It invites the question: why have some litigation financiers steered clear of what plaintiffs lawyers have long recognized is a lucrative area of the legal profession? The answer involves a bedrock rule of American legal ethics, and points to the careful and sometimes divergent ways that litigation funders keep on the right side of its mandate that attorneys not share fees with nonlawyers.
- The gravamen: Litigation funders are tiptoeing around a legal ethics rule that prohibits lawyers from sharing their fees with non-lawyers. But they don’t always take a consistent approach.
- Why it matters: The fee-splitting rule is limiting the types of cases that some funders will back and the way they structure their deals. Some say it’s not meant to apply to litigation finance firms, while others see it as helping safeguard attorney independence.
Bentham takes the position that it cannot fund an individual class action and comply with the so-called fee-splitting ban. Collecting a return on its investment directly from the attorney, in its view, would clearly run afoul of the rule and attempting to contract with hundreds or thousands of class members would be logistically difficult if not impossible. Not to mention that judges would almost certainly frown on a funder attempting to collect on an investment from the class.
Burford, on the other hand, posits that it can bankroll class action lawyers directly as long as the deals are tailored carefully. The financier might, for instance, set the return at a fixed amount rather than as a percentage of the lawyer’s fees, according to Travis Lenkner, managing director of Burford. In an interview last month, he said that class actions are a “quite small” part of the funder’s business.
It’s true that either way the money is paid back from fees the lawyer recovers through a judgment or settlement. But financiers such as Burford view these types of fixed-amount arrangements as akin to traditional financing offered by banks, although investments by litigation funders are often nonrecourse and involve heavy vetting of the underlying legal matter.
The disparate positions adopted by funders highlight just how little clarity there is on the meaning of the fee-splitting ban as it applies to litigation finance. They also demonstrate how the industry is navigating ethical rules that were created long before modern litigation financing developed, in order to tap a legal market that has come under increasing cost pressures.
“I’m sure it’s correct to say that nobody had litigation funding of class actions in mind when they drafted that rule,” said Peter Jarvis, a partner at Holland & Knight and co-author of “The Law of Lawyering.” He added: “I think there is a question that the profession and courts and so forth will need to answer over the next couple years about how to make this work.”
In a class action pending against Chevron Inc. in the Bay Area, a disclosed funding agreement between a pair of California attorneys and U.K.-based Therium Capital Management took something of a hybrid approach, promising Therium six times the $1.7 million it invested in the lawyers, plus 2 percent of all “proceeds.” The money is explicitly to be paid out of the lawyers’ fees under the agreement.
The Bay Area-based Law Finance Group, which frequently funds class actions and was involved in the massive LCD flat panel price-fixing case in the Northern District of California, structures its investments so that the law firm pays back the principal plus an interest rate, said Alan Zimmerman, who heads the company. “We never share the fee with the lawyer,” Zimmerman said. “We get a return.”
Bentham’s decision to stay away from funding class actions appears to be done out of an abundance of caution, amid moves to subject the industry to even more scrutiny.
“I’m not disparaging what our contemporaries feel is acceptable under the ethical rules. What I’m telling you is what we believe, our interpretation,” said Matthew Harrison, head of Bentham’s San Francisco office. “We never want to be accused by anyone—whether it’s the court or an opponent or anyone that we contract with—of being unethical.”
The American Bar Association ban on fee-splitting, established as Model Rule 5.4(a), has been replicated in the codes for attorney conduct by state bars across the U.S. The rule dates back to the early 1900s, and most experts agree it was intended to prevent the kind of situation where a doctor refers an injured patient to a lawyer with the promise of receiving a portion of the lawyer’s fee as a kickback. Ostensibly, it aims to keep lawyers from having their judgment compromised by outside financial interests.
Over the past few decades, as litigation finance has developed, state bar associations have occasionally taken up inquiries from lawyers about whether Rule 5.4(a) would allow or prohibit various financing arrangements. The resulting opinions have not revealed a clear, bright-line rule, according to a forthcoming paper by Anthony Sebok, a professor at Yeshiva University’s Cardozo Law School in New York and a legal ethics adviser to Burford.
The Texas bar’s ethics committee, for example, determined in a 2006 opinion that it would be fee-splitting—and therefore prohibited—if a lender funded an attorney’s litigation expenses on the condition that the attorney repay the amount advanced plus a funding fee equal to a fixed percentage of any amount recovered, when and if the client recovered in the lawsuit.
In an opinion the same year, a North Carolina ethics committee found that a similar nonrecourse loan would not be fee-splitting if the repayment were the principal plus a sum based on an interest rate, and if the breach of the loan agreement would be enforceable against the lawyer’s property. But it would be fee-splitting, it reasoned, if the repayment was the principal plus a percentage of the lawyer’s fees or if the only source of repayment was the lawyer’s contingent fee in the case.
If you think that reasoning seems a bit serpentine, you’re not alone.
“I would say that we are in a current environment where there is confusion about the meaning of Rule 5.4(a) as it extends to finance,” Sebok said in an interview. For his part, he argues that the ethics rules should treat litigation funding no differently than they treat so-called factoring of law firm receivables, a practice in which a law firm sells its accounts receivable to a third party at a discount.
“My view is maybe we should stop forcing people to create transactions according to formalistic boundaries,” Sebok said, “and just create transactions on what’s in the best interest of both parties in the transaction with an eye to risk for interference into the client’s interest.”
The ABA declined to comment for this article.
OTHER FUNDING MODELS
It bears saying that class actions are far from the only time that litigation funders will directly contract with a lawyer or law firm. To the contrary, much of Burford’s business is so-called portfolio funding, where the funder essentially gives a pot of cash to a firm and the return is paid off based on the fees from a basket of cases that the funder assesses. There seems to be a general agreement among funders that this type of “de-coupling” of the investment from any individual case sufficiently quells the notion that the financing might be fee-splitting.
In what is seen as the birthplace of modern litigation funding, in Australia, where Bentham is headquartered, the system for class actions is significantly different from the U.S. Plaintiff attorneys can bring an action on behalf of what is referred to as an “opt-in” or “closed” class, and if a litigation funder is involved, the individuals who consent to join the class generally have to agree to share a portion of their recovery with the funder. Put simply, it is the class members—and not the attorney—who are sharing their payment with the financier.
The lack of clarity about the fee-splitting rule in the U.S. hasn’t stopped some funders from forging ahead. And for the most part, they have gone unchallenged. In the few instances where courts have been confronted with arguments that a funding agreement violates ethics rules—at least in one instance, by a fundee trying to escape having to pay—judges have been unpersuaded, according to Sebok’s paper.
Philip Schaeffer, the former general counsel of White & Case, co-chaired an ABA working group that published a white paper in 2012 on legal ethics and third-party finance. He sees the confusion about what the rule requires as the result of an outdated system of ethics rules.
“It seems to me what you’ve got essentially is it’s a loan to the lawyers that’s secured by the fees. That’s not an extraordinary thing,” Schaeffer said in an interview. “This business is changing very, very quickly and the rules that the ABA have foisted on the country are very, very foolish. They are really antiquated.”
Still, some see these types of arrangements as at least creating a potential pressure point for lawyers, especially if the finance is nonrecourse and the funder has a direct stake in the outcome of the case. “The question that could be asked,” said Holland & Knight’s Jarvis, is “does that kind of funding threaten the exercise of independent professional judgment on the part of the lawyers?”