Mark Chen Published in the Daily Journal, "California's New Consumer Litigation Finance Bill is Laudable, But Imperfect"

May 16, 2023

Mark Chen's article, "California's New Consumer Litigation Finance Bill is Laudable, But Imperfect," was published in the Daily Journal on May 16, 2023. The article is reproduced below, and can also be viewed on the Daily Journal's website here (subscription may be required). 

California's New Consumer Litigation Finance Bill is Laudable, But Imperfect

The bill arms consumers with important rights and protections, but most consumers won’t know how to enforce those rights. Additionally, the bill’s broad application may prevent some victims from obtaining justice.

This February, the California legislature took its first steps toward regulating litigation finance. Senate Bill 581, also known as the “Third Party Litigation Financing Consumer Protection Act,” is currently winding its way through the state’s legislative process, having just passed the Senate Judiciary Committee with unanimous, bipartisan support.

SB 581 imposes registration, reporting, and disclosure requirements on funders and establishes rules governing conduct by funders and counsel. The bill as originally drafted did not distinguish between consumer funders and commercial funders – two unique industries with different norms, practices, and policy considerations – but it has subsequently been amended to focus solely on consumer funding. As the bill’s author, Senator Anna Caballero (D-Merced) explained during a Senate Judiciary Committee hearing, “We’ve narrowed it to the situations where the plaintiff needs some kind of financial support in order to get them through the litigation process and exempted the business-to-business kinds of transactions that help attorneys pay for the litigation costs.”

This new bill is a positive development for the justice system and will help protect vulnerable consumers from unscrupulous lenders and predatory lending practices. However, the bill’s blanket application to all consumer-facing litigation finance also creates hidden dangers. This article examines the bill’s new rules and potential shortfalls. It also examines risks that the bill poses to certain groups of victims.

But first, a quick primer on consumer litigation funding:

Consumer litigation funders lend money to individuals (as opposed to businesses) who are engaged in litigation. Borrowers generally use these loans to cover their medical bills, rent, and personal expenses while waiting for the lawsuit to resolve. As such, the loan amounts are relatively small, often a few thousand dollars each. Nevertheless, access to this financing helps plaintiffs hold out through litigation instead of taking a lowball settlement. The loans are also non-recourse, meaning that the funder can only seek repayment out of whatever funds the individual is able to recover through their lawsuit. Unsurprisingly, many of the individuals who rely on this funding are ill-equipped to evaluate, much less negotiate, their litigation finance agreements, which leaves them vulnerable to exploitation.

Anatomy of SB 581

SB 581 requires that litigation funders register with the Secretary of State and post a surety bond before providing litigation financing to a California resident. The bill also requires all funders (whether consumer or commercial) to submit annual reports to the Secretary of State concerning the funder’s corporate structure and ownership, as well as any consumer funding transactions that the funder has engaged in.

The remainder of the bill’s rules are directed at litigation financing transactions with individuals. SB 581 caps the interest funders can charge to 36% APR, and it further limits the funder’s fees to two years’ worth of interest. The bill also mandates that all consumer funding agreements contain certain disclosures intended to inform consumers of their rights. It also prohibits funders from making or receiving compensated referrals to/from lawyers or medical providers, offering legal advice, assigning or securitizing funding agreements, or exercising control over the consumer’s litigation or settlement. (These latter prohibitions are arguably duplicative of the ethical rules that already apply to legal funders, but the bill’s codification of these rules creates additional enforcement mechanisms, as discussed below.)

For funders who violate any of the above rules, the bill would automatically void the underlying funding agreement, thus depriving the funder the right to recoup their loan. The bill also empowers the California Secretary of State to impose administrative penalties, which includes levying fines and damages as well as barring the funder from engaging in any future consumer lending within the state.

Notably, the bill imposes certain requirements on counsel. Lawyers who take numerous cases on contingency (such as firms that specialize in mass-tort or class actions) commonly utilize litigation financing to help manage their risks and budgets. This typically takes the form of a “portfolio financing” deal, where counsel obtains money from the funder and, in return, promises to the funder a percentage of whatever contingency fees counsel ultimately recovers on their portfolio of cases. SB 581 would require that counsel disclose any such transactions to the clients whose claims make up the portfolio.

Potential shortcomings and unintended consequences

There is no question that regulation is critical to protecting consumers from unscrupulous lending practices, and SB 581 does a commendable job accomplishing that. However, the bill could go further in helping consumers enforce their rights.

For starters, while the bill requires funding agreements to include disclosures stating the consumer’s rights, there remains a question as to how a consumer is to go about enforcing those rights. One of the main reasons why most consumers are vulnerable to predatory lenders is that consumers generally do not know what recourse they have if their rights are being violated (short of filing a lawsuit against the funder, which consumers seeking funding generally can’t afford to do). The bill could alleviate these issues by requiring that consumer funding agreements also contain language explaining the consumer’s options if they believe that their rights are being violated (e.g., language instructing consumers on how to file a complaint with the Secretary of State.)

On the other hand, the bill’s blanket application to all consumer funding transactions may inadvertently cut off some individuals from obtaining justice. Consider, for example, a business founder who was fraudulently forced out of their own company, or an inventor whose invention was stolen by a large company. These individuals’ claims are more akin to the types of complex commercial disputes brought by sophisticated businesses. The legal budgets and expert costs for these cases can easily run into the millions of dollars, with the cases taking many years to resolve. Because these individuals are “consumers” under SB 581, the bill would make it unlawful for them to structure a funding deal that gives the funder more than two years’ worth of interest – even if all the parties recognize that the lawsuit may take twice as long to resolve. These individuals would be hard-pressed to obtain financing under those terms. Consequently, unless they can self-finance or find counsel willing to take the cases on full contingency, they would be unable to vindicate their rights.

Individuals involved in high-stakes, complex commercial disputes are not similarly situated to the consumers that SB 581 was intended to protect. They are in a better position to negotiate with funders (by virtue of them having valuable, high-dollar claims), and their larger funding requirements necessarily require more flexibility in the funding structure than what SB 581 allows. The easiest solution to this problem would be to introduce an additional safe harbor for litigation funding transactions that exceed a certain threshold. For example, Nevada’s consumer funding law applies solely to consumer funding transactions below $500,000. See Nev. Rev. Stat. ch. 604C.100 (2021).

Another concern with SB 581 stems from its inclusion of a provision that would hold consumer funders jointly liable for any monetary sanctions, such as fees and costs, that are assessed against the plaintiff. The intent behind this provision is plain: We don’t want funders speculating on and promoting frivolous claims. But the economics of the funding model already achieves this goal. Because funders can only recoup their investment if the plaintiff prevails, funders have no incentive to support non-meritorious claims — they would just be throwing money away. Holding funders liable for the defendant’s fees and costs would simply discourage funders from funding expensive cases (whether meritorious or not), which are often the ones where the plaintiff needs financing the most.

Notwithstanding these potential issues, SB 581 is a vital step towards bringing more transparency and fairness to the practice of litigation funding. The ultimate goal of litigation funding is to level the playing field for those seeking justice, and the new bill is a welcome move in that direction.

Mark Chen

Senior Investment Manager