Review of New York City Bar’s Opinion on Litigation Financing

By Lazar Emanuel

[Originally published in NYPRR October 2011]

As an observer who has commented several times on developments in the world of litigation financing (See, NYPRR, June 2005, July 2010, February 2011, and May 2011), I was perplexed by the message conveyed by the New York City Bar in its Formal Opinion 2011-2, issued in June (reprinted at the end of this article). In my judgment, the Opinion did not give adequate weight to the two principal legal impediments to litigation financing, specifically the impediments presented by the legal doctrines of usury and champerty. Instead, the Opinion treats the issues created by litigation financing as issues of ethics only, ignoring the broader question: is a particular litigation financing transaction lawful? If a lawyer decides that a particular transaction is unlawful, shouldn’t his inquiries stop there?

The City Bar’s opinion begins as follows:

DIGEST: it is not unethical per se for a lawyer to represent a client who enters into a non-recourse litigation financing arrangement with a third party lender. Nevertheless, when clients contemplate or enter into such arrangements, lawyers must be cognizant of the various ethical issues that may arise and should advise clients accordingly. The issues may include the compromise of confidentiality and waiver of attorney-client privilege, and the potential impact on a lawyer’s exercise of independent judgment. (Note the use of the term lender in the Digest.)

The Opinion goes on to discuss in detail all the ethical hurdles facing a lawyer who represents a client who enters into a litigation financing agreement with a third party, including the impact of Rules 1.2(d); 1.6(a); 1.7(a); 1.8(e), (f); 2.1; 2.2 and 5.4(c). It asks the question: What ethical issues may arise when a lawyer represents a client who is contemplating or has entered into a non-recourse litigation financing agreement? To the extent the Opinion deals with the ethical issues, it’s excellent. To the extent it bypasses the legal issues, it is disappointing.

The Opinion identifies the basic ethical dilemma confronted by lawyers involved in litigation financing agreements:

From the legal ethics perspective, perhaps the greatest concern stems from a financing company’s involvement in the details of a claimant’s case. Because a financing company’s decision to fund will hinge on the company’s analysis of the merits of the lawsuit, i.e., the likelihood and size of the expected return, the availability of financing necessarily depends on the company’s ability to obtain access to information relevant to its assessment of risks of its investment… As part of this process, a financing company may contact the claimant’s lawyer to obtain confidential and privileged information regarding the case before making any loan commitment. And even after funding has been provided, the financing agreements may require litigation counsel to periodically update the financing company with developments in the case and/or provide the company with direct access to the claimant’s file.

Providing financing companies access to client information not only raises concerns regarding a lawyer’s ethical obligation to preserve client confidences, it also may interfere with the unfettered discharge of the duty to avoid third party interference with the exercise of independent professional judgment. While litigation financing companies typically represent that they will not attempt to interfere with a lawyer’s conduct of the litigation, their financial interest in the outcome of the case may, as a practical matter, make it difficult for them to refrain from seeking to influence how the case will be handled by litigation counsel.

Expanding on this basic concern, the Opinion goes on to discuss the various ethical problems facing the lawyer whose client accepts litigation financing from a third party:

1. Attorney as Advisor. If the lawyer recommends a particular source of funding, he is required by Rule 2.1 to give the client candid advice whether the choice is in the client’s best interest. The advice should include the costs and benefits of financing; whether the costs exceed the costs of other options (e.g., bank loans); whether the financing source recommended is the most reasonable source; and whether third-party financing is more beneficial to the client than self-financing.

2. Conflicts of Interest. In referring the client to a financing company, the lawyer cannot accept a referral fee if the fee would compromise a lawyer’s ability to provide candid advice to the client or impair the lawyer’s professional judgment. Also, the conflict rules may prohibit the lawyer, or a company in which he has an interest, from making advances to a client the lawyer represents in litigation.

3. Privilege and Confidentiality. The financing agreement may result in a waiver of the attorney-client privilege. This risk is especially great when the agreement provides that the lawyer disclose his documents and files to the financing source to enable it to evaluate the client’s claim. The agreement may also provide for information about periodic developments in the matter. The lawyer may not disclose privileged information to anyone without the informed consent of the client (the consent need not be in writing). A lawyer should take care to disclose only that information that is necessary in his judgment.

4. Control over the Legal Proceeding. Non-recourse financing agreements often provide that the lawyer advise the financing company of developments in the litigation or to ask for the company’s consent in resolving the law suit, including accepting offers of settlement. These provisions can enable the financing source to protect its own interests to the detriment of the client (e.g., to reject costly discovery). Without the Client’s consent, a lawyer may not permit the financing source to influence his professional judgment in determining litigation strategy, including the decision whether to settle or the amount to accept in settlement.

5. Conclusion. … It is not unethical per se for a lawyer to advise on or be involved with such arrangements. However, they may raise various ethical issues for a lawyer, such as the potential waiver of privilege and interference in the lawsuit by a third party. A lawyer representing a client who is a party, or is considering becoming a party, to a non-recourse funding arrangement should be aware of the potential ethical issues and should be prepared to address them as they arise.

What perplexed me about the City Bar’s Opinion is the simplistic and offhand way in which it dismissed — as though they simply didn’t matter — the legal issues — facing a New York lawyer who represents a client in a non-recourse finance agreement. The issues, as I have said, are Usury and Champerty.

The Impediment Imposed by the Law of Usury

The Opinion’s Digest, supra, characterizes companies that offer litigation financing as “lenders.” This designation is important — “lenders” make loans, and “loans” are governed by the law of Usury. Litigation financing sources do not concede that their investments in law suits should be called “loans.” They argue instead:

[We] provide funds by purchasing a small portion of the anticipated proceeds. It is not a loan, so there is no interest, no matter how long it takes for the case to be resolved. Like the claimant and the attorney, we take the risk of a successful resolution. If the case is lost, we lose our money. (See, www.fastfunds4u.com/pages/faqs.html, City Bar Opinion 2011-2, footnote [7].

New York’s usury laws are spread through a complex network of statutes, most of them in the General Obligations Law and the Banking Law. Section 4.1 of the Banking Law provides:

For the purpose of General Obligations Law section 5-501 and 5-524, … and except as otherwise provided by law, the maximum rate of interest to be charged, taken or received, upon a loan or forbearance of any money, goods, or things in action is as follows: Effective December 1, 1980…16.00% per annum.

The only New York case to consider the effect of a usury claim on litigation financing is Echeverria v. Estate of Lindner, 2005 Slip Op. 50675(u) (Sup. Ct. Nassau County 2005). In Echeverria, Judge Ira B. Warshawsky, was assigned to conduct an inquest into damages sustained by a day laborer who fell from a scaffold. He asked two questions: (i) was the transaction between the laborer and the funding source (LawCash, which claims be to “the Leading Provider of Litigation Financing Funding Plaintiffs and Attorneys”) a loan or an investment; and (ii) was the transaction between them usurious?

Judge Warshawsky’s answer to the first question was:

…it is ludicrous to consider this transaction anything else but a loan. is it a gamble to loan/invest money to a plaintiff in a Labor Law action when there is strict liability? I think not…it is not a gamble but a “sure thing,” therefore, it is a loan, not an investment with great risk.

His answer to the second question was:

The Court finds that LawCash is lending money at usurious rates…the Court awards pre-judgment interest at 16 percent per annum…The clerk shall calculate the interest on $25,000 at 16 percent per annum from the date of the loan.

Nowhere in the City Bar’s Opinion is there a statement that the legal interest rate in New York is generally 16%, or that funding sources which charge more than 25% in interest may be guilty of criminal usury. In an Opinion which instructs lawyers on representing clients who enter into litigation financing transactions, I found the omission of these facts perplexing.

The Legal Impediment of Champerty

Equally perplexing to me was the opinion’s cavalier treatment of champerty as a legal impediment to litigation financing.

While we are aware of no decision finding non-recourse funding arrangements champertous under New York law, lawyers should be mindful that courts in other jurisdictions have invalidated certain financing arrangements under applicable champerty laws. City Bar Opinion 20112, footnote [10].

This statement ignores the fact that New York — like the other states — has a statute that prohibits champerty.

[N]o corporation or association … shall … take an assignment of … a … thing … in action, or any claim or demand, with the intent and for the purpose of bringing an action or proceeding thereon…. Any corporation or association violating the provisions of this section shall be liable to a fine of not more than five thousand dollars; any person or co-partnership, violating the provisions of this section, and any officer, trustee, director, agent or employee of any … co-partnership, corporation or association violating this section who, directly or indirectly, engages or assists in such violation, is guilty of a misdemeanor. NY. Judiciay Law §489(1).

Although the New York courts have shown a reluctance to find champerty in litigation financing, it is the law and should not be ignored by lawyers. See, Rule 1.2(d): A lawyer shall not counsel a client to engage, or assist a client, in conduct that the lawyer knows is illegal or fraudulent, except that the lawyer may discuss the legal consequences of any proposed course of conduct with a client.

The City Bar’s Opinion dismisses the case of Trust, etc. v. Love Funding Corp., 13 N.Y.3d 190 (2009) (See, City Bar Opinion 2011-2, footnote [9]), as a “clarification” of the law of champerty in New York. Actually, it is more than that. It is an important decision by the Court of Appeals in response to questions by the Second Circuit Court of Appeals. The decision distinguishes between (i) a corporation that takes an assignment of a claim with the purpose of suing for losses on a debt instrument in which it holds a pre-existing proprietary interest (non-champertous); and (ii) a corporation which solicits, buys, or takes an assignment of a bond…or other thing in action, or any claim or demand, with the intent and for the purpose of bringing an action…thereon (champertous).

Every New York lawyer consulted by a client who contemplates litigation financing is required to make the same distinction — if the financing is made with the intent and for the purpose of bringing an action, it is champertous.

Editor’s Note: See “City Bar Formal Opinion 2011-2” reprinted below. Not all footnotes in the Opinion are shown, but those which are relevant to this article are discussed above.

Lazar Emanuel is the Publisher of NYPRR.

DISCLAIMER: This article provides general coverage of its subject area and is presented to the reader for informational purposes only with the understanding that the laws governing legal ethics and professional responsibility are always changing. The information in this article is not a substitute for legal advice and may not be suitable in a particular situation. Consult your attorney for legal advice. New York Legal Ethics Reporter provides this article with the understanding that neither New York Legal Ethics Reporter LLC, nor Frankfurt Kurnit Klein & Selz, nor Hofstra University, nor their representatives, nor any of the authors are engaged herein in rendering legal advice. New York Legal Ethics Reporter LLC, Frankfurt Kurnit Klein & Selz, Hofstra University, their representatives, and the authors shall not be liable for any damages resulting from any error, inaccuracy, or omission.

New York City Bar Formal Opinion 2011-2

TOPIC: Third-party litigation financing

DIGEST: It is not unethical per se for a lawyer to represent a client who enters into a non-recourse litigation financing arrangement with a third party lender. Nevertheless, when clients contemplate or enter into such arrangements, lawyers must be cognizant of the various ethical issues that may arise and should advise clients accordingly. The issues may include the compromise of confidentiality and waiver of attorney-client privilege, and the potential impact on a lawyer’s exercise of independent judgment.

RULES: 1.2(d); 1.6(a); 1.7(a); 1.8(e), (f); 2.1; 2.2; 5.4(c)

QUESTION: What ethical issues may arise when a lawyer represents a client who is contemplating or has entered into a non-recourse litigation financing agreement?

OPINION

I. Background

Third party litigation financing first emerged as an industry in the United States in the early 1990s, when a handful of small lenders began providing cash advances to plaintiffs involved in contingency fee litigation. Within a decade, as many as one hundred companies were offering financing to lawyers, their clients, or both. As of 2011, this industry has continued to grow, both as to the number and types of lawsuits financed and financing provided. The aggregate amount of litigation financing outstanding is estimated to exceed $1 billion.

This opinion addresses non-recourse litigation loans, i.e., financing repaid by a litigant only in the event he or she settles the case or is awarded a judgment upon completion of the litigation. Under these arrangements, financing companies advance funds that will be reimbursed, if at all, solely from any proceeds of the lawsuit. As compensation, the financing companies are entitled to receive specified fees, often calculated as a percentage of any settlement or judgment.

Non-recourse loans are extended most often to plaintiffs in personal injury cases. These loans may be used to pay the costs of litigation, but also may be used to cover the plaintiff’s living expenses during the pendency of the lawsuit.

Non-recourse financing of commercial claims is a more recent development, although it has become increasingly common. The providers of this financing typically undertake an analysis of the merits of the contemplated claim that is more rigorous than the analysis employed in personal injury cases. If the claim appears meritorious, the financing company will advance amounts to cover attorneys fees and the other costs of the litigation. These advances typically are made to the claimant or its outside litigation counsel, in return for a percentage of any eventual recovery.

The growing use of non-recourse litigation financing recently has attracted increasing attention, both within and outside the legal profession, in part because the arrangements are largely unregulated, and, in the view of some critics, may require the payment of relatively exorbitant financing fees that appear usurious, create the potential for expanding the volume of litigation, and raise the specter of reviving the historically reviled practice of champerty, defined broadly as the support of litigation by a stranger in return for a share of the proceeds.

From the legal ethics perspective, perhaps the greatest concern stems from a financing company’s involvement in the details of a claimant’s case. Because a financing company’s decision to fund will hinge on the company’s analysis of the merits of the lawsuit, i.e., the likelihood and size of the expected return, the availability of financing necessarily depends on the company’s ability to obtain access to information relevant to its assessment of risks of its investment, both before and after a decision to fund has been made. As part of this process, a financing company may contact the claimant’s lawyer to obtain confidential and privileged information regarding the case before making any loan commitment. And even after funding has been provided, the financing agreements may require litigation counsel to periodically update the financing company with developments in the case and/or provide the company with direct access to the claimant’s file.

II. Analysis

Against this backdrop, we discuss below the ethical issues potentially implicated by non-recourse financing arrangements and examine how lawyers may properly address these issues as they arise.

A. Legality of the Agreement

Whether a particular financing arrangement comports with the law will depend on its terms and governing law, matters outside the scope of this opinion. Nevertheless, under Rule 1.2(d) of the New York Rules of Professional Conduct, if the arrangement is unenforceable under applicable laws, such as those governing champerty and usury, or is otherwise unlawful, an attorney should so advise the client and refrain from facilitating a transaction that is unlawful.

1. Usury

A financing company generally makes its funding determination based on the “merits” of the lawsuit, i.e., on the likelihood of success and the amount of any anticipated recovery. In the same vein, it will seek to set the fee it collects for providing funds based on its assessment of the likelihood of recovery. Fee arrangements vary widely as a result.

Critics have focused on fee arrangements that ultimately require litigants to pay financing companies a substantial portion of any recovery, noting that if the advances made in exchange for these fees were characterized as “loans,” the fees could be deemed usurious. While financing companies generally characterize non-recourse financing arrangements as a “purchase” or “assignment” of the anticipated proceeds of the lawsuit (and therefore not subject to usury laws), lawyers should be aware that in certain circumstances, courts have found that non-recourse litigation financing agreements violate usury laws.

2. Champerty

Champerty is a form of maintenance in which a nonparty furthers another’s interest in a lawsuit in exchange for a portion of the recovery. The law of champerty varies by jurisdiction. While we are aware of no decision finding non-recourse funding arrangements champertous under New York law, lawyers should be mindful that courts in other jurisdictions have invalidated certain financing arrangements under applicable champerty laws.

B. Attorney as Advisor

A lawyer may be asked by a client to recommend a source of third party funding or to review or negotiate a non-recourse financing agreement for a client. if the lawyer does so, Rule 2.1 requires the lawyer to provide candid advice regarding whether the arrangement is in the client’s best interest.

In providing candid advice, a lawyer should advise the client to consider the costs and the benefits of non-recourse financing, as well as possible alternatives. With respect to costs, a common criticism of non-recourse financing is that the fees charged to clients may be excessive relative to other financing options, such as bank loans, thereby significantly reducing the client’s recovery. A lawyer thus should bear in mind the extent to which non-recourse financing will limit a client’s recovery. And before recommending financing companies, a lawyer should conduct a reasonable investigation to determine whether particular providers are able and willing to offer financing on reasonable terms. in addition, if a lawyer assists a client with non-recourse financing, the lawyer may wish to make clear that such assistance itself is not an endorsement of the financing company.

With respect to benefits, a lawyer should advise the client to consider whether, absent funding, the client would be unable to cover litigation or living expenses, or prematurely could be forced into a relatively disadvantageous settlement, effectively limiting his or her access to seek redress through the legal system. Commercial claimants also may lack the resources to pursue a claim absent funding, or may be able to deploy resources more effectively for their business needs by financing some or all of their litigation costs.

C. Conflicts of Interest

Non-recourse financing arrangements also may result in waiver of the attorney-client privilege or other protection from disclosure. This risk arises from provisions requiring a claimant or his or her lawyer to disclose documents and information to financing companies to enable them to evaluate the strength of the claims in the litigation to be financed. In addition, financing arrangements may require a lawyer to inform the financing company of developments in the case and/or allow periodic reviews of the case file. And for very large claims, some financing companies reserve the right to share information regarding a matter with other companies that may participate in the financing.

This opinion does not address whether such communications between the client or lawyer and a financing company result in a waiver of the attorney-client privilege or other applicable protection. We note, however, that the argument has been made that the common interest privilege does not apply to such communications because the financing company’s interest in the outcome of a litigation is commercial, rather than legal.

With the foregoing in mind, a lawyer may not disclose privileged information to a financing company unless the lawyer first obtains the client’s informed consent, including by explaining to the client the potential for waiver of privilege and the consequences that could have in discovery or other aspects of the case. In making disclosures to the financing company, a lawyer should take care not to disclose any more information than is necessary in his or her judgment.

E. Control Over the Legal Proceeding

Non-recourse financing agreements often require the claimant’s lawyer to keep the financing company apprised of any developments in the litigation or to seek the company’s consent when taking steps to pursue or resolve the lawsuit, such as making or responding to settlement offers. These notice provisions raise the specter that a financing company, armed with information regarding the progress of the case, may seek to direct or otherwise influence the course of the litigation. For example, to protect its own interest in maximizing the fee it may earn, a financing company may object to steps calculated to advance the client’s interests, such as pursuing a promising line of additional discovery at a cost the company would prefer to avoid, or accepting a settlement offer that does not meet the company’s expectations regarding the return on its investment. While a client may agree to permit a financing company to direct the strategy or other aspects of a lawsuit, absent client consent, a lawyer may not permit the company to influence his or her professional judgment in determining the course or strategy of the litigation, including the decisions of whether to settle or the amount to accept in any settlement.

III. Conclusion

Non-recourse litigation financing is on the rise, and provides to some claimants a valuable means for paying the costs of pursuing a legal claim, or even sustaining basic living expenses until a settlement or judgment is obtained. It is not unethical per se for a lawyer to advise on or be involved with such arrangements. However, they may raise various ethical issues for a lawyer, such as the potential waiver of privilege and interference in the lawsuit by a third party. A lawyer representing a client who is party, or considering becoming party, to a non-recourse funding arrangement should be aware of the potential ethical issues and should be prepared to address them as they arise.

Lazar Emanuel Litigation Financing