Those who advocate using economic theory to analyze law argue that economic efficiency is a test for determining when a legal rule makes sense. Under this analysis, rules that would expressly or effectively prohibit third-party litigation finance do not make sense. This is because the availability of litigation finance greatly promotes efficient outcomes in settlement agreements.
From an economic perspective, the purpose of a settlement is to allow the parties to reach an outcome that corresponds with what the outcome of a trial would be, but without the cost of a trial in attorneys’ fees and other litigation costs. When they correspond with trial outcomes, settlements achieve just results with lower costs. The cost savings is where the economic efficiency is found.
It is impossible for a settlement to reach this kind of efficient outcome if one of the party’s decision-making about settlement is driven primarily by cost factors or an excessive aversion to risk. When cost or risk drive settlement decisions instead of an assessment of the value of the claim, defendants can avoid costs when they should not, or plaintiffs may reap excessive gains.
In many cases, such inefficient settlements occur because one party has a different risk preference than the other. For example, if the plaintiff in a lawsuit is a one-time player while the defendant is a repeat player, the risk imbalance favors the defendant, because one-time players cannot spread risk over several rounds of litigation. Consequently, the plaintiff has the incentive to settle at a lower level of recovery than the merits of the case would warrant. On the other hand, in mass consumer class actions, a well-organized plaintiff class with a strong claim will probably be more risk tolerant than the defendant who faces a huge, one-time judgment. In these situations, settlement outcomes will not be efficient.
Litigation financing can mitigate these disparities in risk tolerance. Introducing a risk-neutral repeat player on the side of the risk-averse party can reduce the imbalance, placing the parties in better negotiating position. In this way, litigation financing can produce fairer settlements that save money for the parties in a particular case and for the civil justice system as a whole.
Topics: litigation finance, legal reform, third-party funding, litigation costs, legal costs, economics of law practice, law and economics, efficient settlements
Geoffrey McGovern, et al., Third-Party Litigation Funding and Claim Transfer: Trends and Implications for the Civil Justice System (2010), available at http://www.rand.org/pubs/conf_proceedings/CF272.html