February 16, 2022
In a previous blog post , we asked whether litigation finance is a good thing for our legal system, and we focused on how funding affects parties’ behavior after a legal claim accrues. That is the terrain of most debates about litigation finance: whether it improves claimants’ access to the courts and results in better, fairer outcomes in court cases.
In this post, we focus on a mostly overlooked, but potentially no less important, impact that litigation finance may have on society: its effect on parties’ behavior before a legal claim ever arises in the first place. We focus here on a breach of contract action, perhaps the most common claim backed by commercial litigation funders like Validity.
Fewer Contract Breaches
One real-world impact that litigation finance is likely to have: it should decrease the likelihood that parties improperly breach their contracts.
Why do parties breach their contracts? Sometimes a promisor breaches its contract for economically rational and welfare-maximizing reasons: specifically, when the expected total cost of abiding by a contract exceeds the cost of breaching the contract, paying damages, and engaging in another more efficient economic transaction. These are called “efficient breaches,” and they are welfare-maximizing breaches that many practitioners and economists might actually encourage.
Importantly, the efficient breach theory presumes that a party breaches and pays damages. As we all know, this doesn’t always happen. In the real world, the breaching party does not immediately pay damages after breaching its contract. Indeed, promisors may breach their contracts in part because they expect they will probably not pay any or most of the damages they ought to pay.
For example, promisees (the non-breaching party) may not challenge or even detect a contract breach, and even if they do, resolution can be quite costly. Promisees may not have the money to hire the highly skilled counsel or experts needed to win, or monetary constraints may force them to settle for less than the full value of their claims. Even if claimants litigate through trial, the judge or jury may find that no breach occurred, or they may award less than the full amount of damages.
Under these circumstances, parties may be more likely to breach their contracts, even though these breaches are not “efficient breaches.” This is where litigation finance can make a difference.
Litigation finance increases the likelihood that the promisee will successfully challenge a breach, and it makes the amount of damages that the breaching party expects to pay more closely approximate the amount of damages actually incurred by the nonbreaching party. In other words, the potential for litigation finance may force promisors to more accurately consider the full costs of a breach, resulting in fewer instances in which the benefits of breaching exceed the costs, resulting in a net deterrent effect against contract breaches.
In short, litigation finance operates as an “enforcement mechanism,” making it more likely that a party can successfully enforce its legal rights, and thus deterring counterparties from improperly breaching their contracts.
Litigation finance may also have another effect on parties before a legal claim arises: it may actually make parties more likely to enter into commercial contracts.
A promisee’s willingness to enter into a contract depends on at least two factors: First, the promisee’s confidence that the promisor will adhere to its promise. And second, the promisee’s confidence that, if the promisor breaches, the promisee will obtain redress for the breach.
Litigation finance affects both factors. First, as explained above, litigation finance deters promisors from breaching their contracts without paying damages. Thus litigation finance should give promisees more confidence that their counterparties will abide by their promises.
Second, litigation finance makes it more likely that if the promisor breaches, the promisee can obtain redress in court. Observers as far back as John Hobbes have argued that a system of impartial courts to enforce agreements is an essential ingredient to a functioning system of contracts. And it is not enough that courts simply exist: parties must be able to affordably access those courts. Litigation finance helps parties do just that. Funding plays a similar role in our legal system as do norms against oppressively high court filing fees, contributing to a legal system where parties that enter into contracts can have confidence that their agreements can be enforced in court if necessary.
By decreasing the likelihood of inefficient contract breaches and increasing access to courts, litigation finance gives parties to contracts more confidence that their agreements will be enforced, and thus is likely on balance to increase the incidence of contracting.
In sum, litigation finance is likely to affect parties’ behavior before a claim arises in at least two ways: first, by deterring inefficient breaches, and second, by increasing the rate of contracting. These are likely to increase efficiency and welfare. When regulators consider potential regulation of litigation finance, they must consider these salutary effects, lest they impose regulations that unduly suppress these positive effects of funding.
This blog post is adapted from Suneal Bedi & William C. Marra, The Shadows of Litigation Finance, 74 Vand. L. Rev. 563 (2021).