Litigation Finance: A Market Solution to a Procedural Problem

Abstract

In a system dominated by settlement, scholars, lawyers, and judges who want to promote accuracy in litigation strive to promote accurate settlements. This effort typically relies on judicial intervention in pretrial practice, or on extrajudicial substitutes, to educate parties on the merits of their positions and induce them to settle for amounts that reflect those merits. The goal is to make pretrial resolutions look more like adjudicated resolutions, albeit with less expense.

These reform efforts largely fail to address a major force that can skew settlements away from the merits: imbalances in risk preferences. Settlements are a product not only of the parties’ expectations for trial but also of their tolerance for risk. In deciding whether to settle or proceed to trial, parties must compare a given settlement amount with a range of possible trial outcomes, the precise distribution of which is uncertain. When parties choose between a certain outcome and an uncertain outcome, their choice will be affected by their risk preferences. And where one party is a repeat player and the other is a one-time participant, they will have very different risk tolerances — the one-time, risk-averse participant will be more fearful of proceeding to trial, more eager to settle, and in a weaker bargaining position.

When imbalances in risk preferences skew settlements away from the merits, this is just as much a market failure as a failure of procedure. Unlike the efficient markets we rely on to price all sorts of assets and liabilities, the market for litigation claims is uniquely limited to just two participants. The plaintiff can sell only to the defendant and the defendant can deal only with the plaintiff. For this reason, imbalances in risk preferences can lead to the mispricing of lawsuits.

If we want the settlement process to value lawsuits accurately, perhaps we should do the opposite of what scholars have done in the past. We should consider making settlements look less like adjudications and more like market transactions. If a party to a lawsuit is poorly equipped to bear litigation risk and fearful of being coerced into an unfair settlement, we would not rely on judicial intervention to save him. Rather, we would empower the party to help himself via a market transaction. If the weaker party could off-load risk via the market to someone better able to bear it, he might be able to counter the stronger party’s bargaining advantage. Indeed, by enlisting the help of a third party that holds a diverse portfolio of litigation risk and is better able to bear such risk, the weaker party could bolster his negotiating position and secure a settlement that reflects the merits of the lawsuit rather than the bargaining positions of the parties.

This Article compares traditional approaches to promoting accuracy with an alternative, market-based approach. It considers the nascent litigation markets that exist in this country and abroad, and the obstacles that have prevented their maturation into a viable solution. Finally, the Article considers reforms to foster a more robust litigation market. The goal is to shed new light on a litigation finance industry long viewed by the legal profession and the academy with disdain. The Article recasts litigation finance as a potential engine for good — a force that may promote accuracy in adjudication where conventional reform efforts have failed.

Keywords: litigation, litigation finance, settlements, bargaining, negotiation, juriprudence

JEL Classification: K41, K49