March 2020 Ethically Speaking - A Closer Look at the State Bar’s Proposed Ethics Opinion on Alternative Litigation Funding

by Michael D. Stewart

As a California attorney, do you have an obligation to advise your client about litigation funding? If so, are you charged with explaining to your client the pros and cons of such funding? According to the California State Bar, the answer may be yes. See Proposed Formal Opinion Interim No. 14-0002 Alternative Litigation Funding (“To the extent the client’s ability to accomplish its objectives depends on the client’s ability to fund the litigation . . . the lawyer’s representation of the client may involve advising the client as to whether litigation funding would assist in accomplishing the client’s goals. Such advice would likely need to include a discussion of the pros and cons of obtaining litigation funding and alternatives, if any.”).

Whether or not the above-referenced ethical obligations will find their way into the final opinion remains to be seen, but there is no doubt that litigation funding can both be complicated and implicate conflicts of interest. Apart from any ethical duties, litigation funding could be an avenue to increase your client’s ability to pay for your services. Additionally, there are myriad issues the attorney needs to know about the process that will impact his or her representation. On the defense side, an adversary’s litigation funding could be fertile ground for discovery, and of course the existence of such funding might impact defense strategy—just as the existence of a defendant’s insurance coverage may impact a plaintiff’s strategy.

Different Types of Litigation Funding

There are several different types of litigation funding (also described as litigation financing). Some funders will provide financial support to pay a personal injury plaintiff’s personal expenses, as opposed to funding the legal fees and/or costs to prosecute the claim. This article focuses on commercial funding, where the funder and client (and sometimes the attorney) enter into a funding agreement to pay the legal fees and/or costs for a single case (there is also portfolio funding for a group of cases) for which the funder is reimbursed from the recovery, if any, in the litigation.

The Funding Agreement and How Litigation Funding Works

There are various litigation funding companies and, not surprisingly, they have different approaches and different provisions in their funding agreements. However, they generally have the following hallmarks.

The client or its attorney will contact the litigation funder and go through an initial vetting process. Assuming both parties wish to proceed, they may enter into an interim agreement allowing the funder to more thoroughly assess the merits of the claim before entering into a binding funding agreement. Alternatively, the parties may at the outset enter into a funding agreement that allows the funder to withdraw if it determines it is not interested in funding the litigation. Either way, the funder will likely insist on exclusivity, meaning the client and attorney are prohibited from shopping for another funder for a period of time while the funder expends resources assessing, among other things, the merits of the claim, the financial wherewithal of the defendant, procedural considerations, possible insurance recovery, and the acumen of client’s attorney or law firm.

The funding agreement itself will likely be complex. As reflected in the above-referenced proposed State Bar opinion, “a lawyer representing a client in a matter funded by a litigation funder has an obligation to understand how the funding agreement impacts the litigation and advise the client.” Furthermore, if “the client asks the lawyer to advise on or negotiate a litigation funding contract, the lawyer must either have the expertise to do so, obtain such experience, or decline to provide the requested advice regarding litigation funding.” Finally, “regardless of whether the attorney is advising her client on the funding contract, she must understand how the terms of the funding agreement impact decisions in the litigation.” Simply put, if you do not have the expertise to represent your client in negotiating the funding agreement, you should not take on that task—at least not without obtaining the requisite expertise. But even if you do not negotiate the agreement, you must still understand how the terms of the agreement may impact how the case is handled or resolved.

Generally, the most appealing aspect of the funding arrangement from the client’s perspective is that it is designed to be non-recourse. The funder will only be repaid if the case results in a settlement or collected judgment, subject to certain very important exceptions. Specifically, the agreement will have certain non-recourse carveouts which, if triggered, can make the client liable for not only the amount the funder has expended but often additional amounts or premiums. The carveouts may include, among other things, a misrepresentation to the funder by the client or its attorney during the underwriting or due diligence phase, the concealment of material information from the funder, certain “breaches” of the funding agreement, accepting a settlement for less than the amount funded, and dismissing the lawsuit without funder consent. Obviously, it is important to understand and inform the client of any recourse consequences, including those that might arise as the case progresses.

The funding agreement may also require an administrative or origination fee that comes off the top of the amount to be funded. The amount of that fee could be 10% or even more. There could also be a break-up fee, as well as a fee or prohibition if the funding amount is expended and the client enters into a successor funding arrangement. The funding agreement may also provide the funder with a right of first refusal with respect to any additional funding, which could tend to chill another funder’s interest. The funding agreement will likely allow the funder to cease funding upon certain circumstances, such as a change in law, the defendant’s financial distress, or other material adverse change. As touched on above, like any contract representation, the attorney must possess the competency to understand and negotiate such provisions (California Rules of Professional Conduct, hereinafter “CRPC,” Rule 1.1) and must communicate their import to the client (CRPC Rule 1.4). The latter duty extends to post-contract formation, as many of the funding agreement provisions mandate continued monitoring and compliance.

Focusing more on the attorney’s role, the funding company will want to review and approve the attorney’s budget for the case. Subject to the agreed-upon amount of funding, the funder will likely pay all costs but require the attorney to defer a portion of his or her fees, which will only be paid if the case is successful. The funding agreement may even require the attorney to agree, sometimes in an addendum, to not withdraw from the representation if the funding is exceeded—sometimes even if the client cannot or will not pay the attorney during the remainder of the case. While “everything’s negotiable,” any such arrangement could impact the attorney’s rights and duties under CRPC Rule 1.16 (“Declining or Terminating Representation”).

Additionally, the funding agreement will almost certainly require the attorney to agree to act as the custodian of any funds received in settlement or otherwise, subject to their distribution under a waterfall mechanism set forth in the agreement (discussed below). Like many of these issues, this could create a conflict of interest where the attorney is contractually bound to the funder to potentially not comply with the client’s directions to disburse the proceeds in a certain manner.

The prudent attorney will not simply file-away the funding agreement, but instead (a) explain its provisions and possible conflicts of interest in the client engagement letter (or otherwise in writing), and (b) review its terms throughout the progress of the case, and certainly before taking or allowing the client to take certain actions that may impact the client’s obligations to the funder (e.g., settlement, withdrawal, switching or adding counsel, obtaining additional funding, etc.).

Concerns About Confidentiality of Communications With the Funder

Like the tripartite relationship involving an insurance carrier, a litigation funding arrangement can implicate the attorney’s duty of confidentiality. Imagine, for example, a judge allowing the defendant to discover the case assessment memo provided to the funder, replete with candid comments about weaknesses in the case, potentially damaging witnesses, conflicting internal documents, or feared affirmative defenses. Even worse, imagine the memo is shown to the jury—with you or your client having to testify about its contents.

The facile response is do some research and conclude that communications with a litigation funder are either privileged or not. But the answer is not black or white. The law, like the litigation funding industry itself, could be described as in its infancy. Most decisions turn on whether the court finds that the funder has a “common interest” with the client such that the attorney-client privilege extends to such communications. Most courts will find a common interest, but some have declined to do so. And of course that determination depends on the context. For example, privilege and work-product protections are less likely to be found where the parties are in an adversarial posture, either during initial negotiations or if there is a mid-case dispute amongst them.

Additionally, if the client prepared the memo to the litigation funder without attorney involvement, it is difficult to imagine how a privilege could apply. Even if the attorney prepared and submitted the memo, if the attorney sent it via an email blast to ten potential funders it might be an uphill battle convincing the court it was a confidential communication. See, e.g., Leader Techns., Inc. v. Facebook, Inc., 719 F. Supp. 2d 373 (D. Del. 2010) (common interest did not apply to documents provided to litigation funding companies during initial negotiation stage).

The funding agreement will contain confidentiality provisions and may even reflect the parties’ “agreement” not to share attorney-client communications. Even so, the funder may feel compelled to ask for all manner of information from the attorney, especially at crucial stages during the litigation. It is easy to suggest that the attorney should never disclose any confidential information to the funder, but that tact might at times actually be counter-productive to the client’s interests or potentially violate the terms of the funding agreement. The attorney, perhaps fearing the funder will cease funding or take other action possibly detrimental to the client or the attorney, may feel compelled to divulge confidential information to the funder. Ultimately, the attorney, in consultation with the client, may be faced with a judgment call.

The Attorney’s Duties of Loyalty and Independence

Similar once again to the tripartite relation-ship involving an insurance carrier, litigation funding can implicate the attorney’s duties of loyalty. The better litigation funding companies will use a funding agreement expressly stating they will not interfere with the attorney’s conduct, judgment, or strategy. Nevertheless, the financial incentives might cause the funder to seek to influence case strategy. For example, the funder (and possibly the attorney) might not share the client’s enthusiasm for delving into extensive (and expensive) discovery to support a freshly-minted quest at injunctive relief—even though the funding agreement will likely state non-monetary relief will be quantified and compensable to the funder.

The attorney owes duties of loyalty and independent professional judgment to the client, not the litigation funding company. The CRPC could be implicated in at least three ways. First, under CRPC Rule 1.7(b), the attorney cannot accept or continue the representation if “there is a significant risk” such representation “will be materially limited” by the attorney’s own interests or the attorney’s responsibilities to a third person, such as a litigation funder. However, that conflict can generally be waived with the client’s informed written consent, and therefore the attorney should set forth the potential financial interests and conflicts he or she may have in the client engagement letter.

Second, even if there is not a significant risk of a conflict of interest, CRPC Rule 1.7(c) requires that the attorney disclose to the client if he or she has (or knows that someone in his or her law firm has) a “legal, business, financial, professional, or personal relationship” with the litigation funding company. This may be the case if the attorney (or an attorney within the firm) has previously worked with the litigation funder.

Third, CRPC Rule 1.8.6 requires the client to provide informed written consent to the funding company’s payment of fees to the attorney. This also includes a referral fee, if any. The same rule prohibits the attorney from being influenced by the payor’s potential “interference with the lawyer’s independent professional judgment or with the lawyer-client relationship.”

These duties need to be understood in context. A litigation funder is different than an insurer. The insurer bargains that the premium (or years of them) will ultimately outweigh the risks of a potential claim that is covered under the policy. The funder agrees to contribute six or seven figures in legal fees and/or costs on behalf of a stranger for a potential share of litigation proceeds resulting from an unpredictable process over which they have little control. For that reason, a typical funding agreement will require the parties to work together to a degree with which the attorney may be unfamiliar. One example is a “cooperation” provision that is often far more detailed and expansive than the type found in an insurance policy or other commercial contract. It could include extensive provisions regarding repercussions to the client upon accepting or rejecting settlement below or above a certain amount, initiating “adverse” actions, filing a bankruptcy petition, etc. In fact, the cooperation provision required by one well-known litigation funding company states that cooperation “is of the essence” of the agreement.

Ultimately, the attorney owes a duty of loyalty to the client but, as the agent of the client, must be careful to not inadvertently place the client in potential violation of the funding agreement, especially where it could result in a cessation of funding.

How Case Proceeds Are Apportioned

The funding agreement will set forth a waterfall explaining how case proceeds are apportioned. Funders can differ widely on deal terms, some of which may vary depending on the merits of the case and prospects for recovery. Some funders will fund less of the anticipated legal budget than others, leaving the client to pay the overage. Some will require the attorney to defer a higher percentage of fees than others. The attorney will want to explain to the client the ramifications of such terms, including any potential conflicts of interest which the attorney may face (e.g., suggesting the client accept one funding arrangement over another).

The funder will almost certainly insist on being repaid on a priority basis the full amount it expended, often plus a premium. The funder may then allow the attorney to be paid his or her deferred fee. The funder then may again insist on priority for an additional premium before the client receives any proceeds. Generally speaking, the funder will negotiate for a higher return the longer the case takes to resolve. Again, the terms vary widely and the keen client or attorney may wish to approach several litigation funding companies.

As mentioned earlier, the funding agreement will likely address how to quantify non-monetary relief and apportion to the funder a certain portion or percentage of such value. Some funding agreements may even require the client to “sell” the injunctive or other non-monetary relief if the client cannot come up with the payment to the funder. Whether that is a viable prospect will depend on the circumstances.

The Pros and Cons of Litigation Funding

There are certainly cheaper sources of financing than those offered by litigation funders. In fact, the potential recoveries under a typical funding arrangement might make a hard-money lender blush. However, there is a major distinction between a traditional loan and litigation funding—the latter is non-recourse (subject, again, to any carveouts set forth in the funding agreement). There are several ways the litigation funder can lose some or all of its investment. The defendant could go out of business or otherwise be unable to pay a settlement or judgment. The law could change. The defendant could appeal. There could be competing demands on the proceeds, such as those made by a trustee if the client were to file bankruptcy. And, of course, the client could lose the lawsuit.

Some clients may find the funder’s potential investment return acceptable, even favorable. The client may otherwise have no ability to pursue meritorious litigation. Or some clients may choose to forgo other means of financing in favor of sharing the litigation risk with a funder.

Turning to the attorney’s role, and as mentioned above, the State Bar’s proposed opinion cautions the attorney advising a client considering litigation funding that “[s]uch advice would likely need to include a discussion of the pros and cons of obtaining litigation funding and alternatives, if any.” Following that notion to its conclusion might impose on the attorney a duty akin to a financial advisor. The State Bar may wish to soften such suggestion to avoid the implication that the attorney owes such duties, unless of course the attorney engages in such advice, negotiation and related tasks. The attorney may wish to expressly exclude such tasks from the scope of services set forth in the client engagement letter; however, even if the attorney does so, in order to competently represent and protect the client’s interests, the attorney should understand how the terms of any funding agreement the client enters into may impact the case or the attorney’s or client’s obligations to the funder.

Michael D. Stewart is a partner and Deputy General Counsel of Sheppard, Mullin, Richter & Hampton LLP, in Costa Mesa. He is also a member of the OCBA’s Professionalism & Ethics Committee. The views expressed herein are his own and not those of this publication or his law firm. He can be reached at mstewart@sheppardmullin.com.