Third party funding

What Is Third-Party Funding?

Third-party funding is a financial arrangement where an independent entity, with no direct involvement in a legal dispute, provides capital to a party involved in that dispute. This funding typically covers legal expenses and disbursements, in exchange for a share of any proceeds recovered if the claim is successful⁶⁴. It falls under the broader financial category of Alternative finance, representing non-traditional ways to secure investment capital outside conventional banking or equity markets⁶¹, ⁶², ⁶³.

The core principle of third-party funding is its "non-recourse" nature: if the funded party loses the case, they are generally not obligated to repay the funder's investment⁵⁹, ⁶⁰. This shifts significant legal costs and financial risk management away from the claimant, enabling individuals or businesses to pursue meritorious claims they might otherwise be unable to afford⁵⁶, ⁵⁷, ⁵⁸.

History and Origin

The concept of external parties supporting legal claims has ancient roots, with practices similar to third-party funding appearing in ancient Greece and Rome, though often met with social disapproval and subsequent regulations due to concerns about their motives⁵⁵. Modern third-party funding, however, began to emerge more formally in common law jurisdictions. Its commercial application first developed in Australia in the 1990s, particularly in insolvency proceedings and class actions, as a response to the escalating costs of litigation⁵³, ⁵⁴. Early on, its legality was often challenged, but Australian case law, notably the 2006 High Court decision in Campbells Cash and Carry Pty Ltd v Fostif Pty Ltd (commonly known as Fostif), provided clarity and largely affirmed its permissibility where doctrines like "maintenance" and "champerty" had been abolished⁵².

From Australia, third-party funding expanded into the United Kingdom and the United States in the early 2000s, driven by a need for access to justice and a means for companies to manage litigation risk⁵⁰, ⁵¹. The industry has experienced significant growth, transforming from an "obscure corner of Wall Street" to a multi-billion dollar sector, attracting interest from major capital markets players and large law firms seeking to offer clients alternative financing options⁴⁹. Reuters reported on the increasing trend of litigation funding, highlighting its rapid expansion as a new asset class drawing more investors⁴⁸.

Key Takeaways

Third-party funding involves an external investor covering legal expenses in exchange for a share of successful case proceeds.
It operates on a "non-recourse" basis, meaning the funder loses their investment if the case fails, shielding the funded party from financial loss⁴⁷.
The practice significantly reduces the financial burden and risk for claimants, enhancing access to legal recourse⁴⁶.
Originating in Australia in the 1990s, it has grown into a global industry, becoming a recognized tool in dispute resolution and corporate finance.
It is distinct from a traditional contingency fee arrangement, where the lawyer takes a percentage of the outcome.

Interpreting Third-Party Funding

Third-party funding is typically interpreted as a strategic financial tool rather than a loan. For claimants, it represents a way to transform a potential legal claim into a financial asset, allowing them to pursue cases without impacting their balance sheet or liquidity⁴⁴, ⁴⁵. The terms of third-party funding agreements vary widely but generally involve a detailed due diligence process by the funder to assess the merits and potential value of the claim.

Funders evaluate the likelihood of success and the anticipated return on investment (ROI) from the potential damages or settlement. If the case is successful, the funder receives their invested capital back, plus an agreed-upon share of the proceeds, which might be a fixed percentage or a multiple of the invested amount⁴³. This structure aligns the funder's interests with the funded party's success, as the funder only profits if the claim yields a positive outcome.

Hypothetical Example

Imagine "Green Solutions Inc.," a small renewable energy startup, discovers that a larger competitor, "MegaCorp," has infringed upon its patented solar technology, potentially costing Green Solutions millions in lost revenue. However, Green Solutions lacks the immediate cash flow to fund a protracted patent infringement lawsuit against MegaCorp's well-resourced legal team.

Instead of abandoning their claim or settling for a meager amount, Green Solutions approaches a third-party funding firm. After extensive due diligence on the patent's validity and the strength of the infringement claim, the funder agrees to cover all legal expenses, including attorney fees, expert witness costs, and court fees. In return, the funding agreement stipulates that if Green Solutions wins the lawsuit or reaches a settlement, the funder will receive a predetermined share of the recovered damages (e.g., 30% of the net proceeds after expenses are reimbursed to the funder) and the initial capital invested. If the lawsuit is unsuccessful, Green Solutions owes nothing to the funder, effectively transferring the financial risk management to the funding firm. This arrangement allows Green Solutions to pursue justice and potentially secure a substantial recovery without draining its operational capital.

Practical Applications

Third-party funding is increasingly prevalent across various legal and commercial domains, providing liquidity and risk transfer.

Commercial Litigation: Businesses of all sizes, from startups to large corporations, use third-party funding to finance complex commercial disputes, intellectual property claims, and breach of contract cases⁴¹, ⁴². This allows them to pursue strong claims without impacting their balance sheets or diverting funds from core business operations.
International Arbitration: The practice is particularly well-established in international arbitration and investor-state dispute settlement (ISDS), where legal proceedings can be exceptionally long and costly³⁹, ⁴⁰. Organizations like the International Centre for Settlement of Investment Disputes (ICSID) have even introduced rules for disclosing third-party funding arrangements to ensure transparency³⁸. The ICSID's Practice Note on Third-Party Funding provides guidance on its use in such disputes³⁷.
Class Actions and Mass Torts: Third-party funding plays a crucial role in enabling large-scale collective actions where individual claimants might have relatively small damages but, collectively, the claim is substantial³⁶. This makes access to justice economically viable for groups who would otherwise be unable to afford litigation³⁵.
Portfolio Funding: Some funders invest in a portfolio of cases for a law firm or a corporation, diversifying their risk across multiple claims rather than relying on a single outcome³³, ³⁴. This can provide continuous financial support for legal departments or firms with recurring litigation.
Monetization of Awards: Funders may also provide immediate capital against an anticipated award or judgment, allowing claimants to monetize their future recovery earlier³².

Limitations and Criticisms

Despite its growing acceptance, third-party funding faces several limitations and criticisms, particularly regarding transparency, control, and ethical considerations.

Transparency and Disclosure: A primary concern is the lack of mandatory disclosure requirements in many jurisdictions, which can obscure the identity of funders and the terms of their agreements³⁰, ³¹. Critics argue this secrecy can lead to undisclosed conflicts of interest, especially if a funder has a relationship with an opposing party, the tribunal, or the lawyers involved²⁸, ²⁹. While some international arbitration rules, like those from ICSID, have moved towards requiring disclosure of funder identity, broader universal standards are still developing²⁶, ²⁷.
Funder Control and Lawyer Independence: Concerns exist that funders, with a direct financial interest in the outcome, might exert undue influence over litigation strategy, settlement decisions, or even the choice of legal counsel²⁴, ²⁵. This could potentially compromise the professional independence of lawyers and their fiduciary duty to act solely in the client's best interest²¹, ²², ²³.
Encouraging Frivolous Litigation: Opponents argue that the availability of third-party funding might incentivize the filing of unmeritorious or speculative lawsuits, as the financial risk to the claimant is minimized¹⁹, ²⁰. This could potentially strain judicial resources and increase the costs of doing business for defendants¹⁸.
Distribution of Proceeds: Another criticism is that a significant portion of any successful recovery may go to the funder, potentially leaving the plaintiff with a reduced net recovery after all fees and expenses are deducted¹⁷. The Financial Times has reported on the controversies surrounding the ethics and transparency of litigation funding¹⁶.
Regulatory Uncertainty: The relatively nascent and evolving nature of the industry means that regulatory frameworks are often inconsistent across jurisdictions, leading to legal uncertainty and varying standards of practice¹⁵.

Third-Party Funding vs. Litigation Finance

While often used interchangeably, "third-party funding" and "litigation finance" refer to closely related, but sometimes distinct, concepts.

Third-party funding is the broader term encompassing any arrangement where a party not directly involved in a legal dispute provides capital to one of the litigants. This can extend beyond just litigation to other types of financial support for legal costs or even general business expenses, sometimes secured by future legal claims. The key element is that a "third party" provides the funding.

Litigation finance, on the other other hand, is a specific application of third-party funding that focuses exclusively on financing legal disputes, such as commercial lawsuits or arbitration proceedings¹², ¹³, ¹⁴. It explicitly refers to the investment in a legal claim itself, where the return is contingent on the successful outcome of that particular litigation or arbitration¹¹.

In essence, all litigation finance is a form of third-party funding, but not all third-party funding is necessarily litigation finance. For example, a loan backed by future receivables that happen to include potential legal recoveries could be seen as a form of third-party funding, but it might not strictly be considered litigation finance if the primary purpose isn't to finance the lawsuit itself. However, in modern financial discourse, the terms are frequently used synonymously, reflecting the dominant application of third-party funding in the legal sector.

FAQs

How does third-party funding differ from a traditional bank loan?

A traditional bank loan typically requires collateral and must be repaid regardless of the borrower's success in a venture. Third-party funding for legal claims is generally "non-recourse," meaning the funded party only repays the funder and pays a success fee if the legal case is won or settled favorably. If the case is lost, the funder bears the financial loss, and the funded party owes nothing⁹, ¹⁰.

Who typically uses third-party funding?

Third-party funding is used by a wide range of entities, including individuals, small and medium-sized enterprises (SMEs), and large corporations⁸. It is particularly attractive to those who have strong legal claims but lack the immediate liquidity to bear the high legal costs and risks associated with complex litigation or international arbitration.

Is third-party funding regulated?

Regulation of third-party funding varies significantly across jurisdictions globally. Some countries and arbitral institutions have introduced specific rules regarding disclosure and transparency, while others have less formal oversight⁶, ⁷. This evolving regulatory landscape means that parties considering third-party funding should conduct thorough due diligence and seek legal counsel.

What are the main benefits of using third-party funding?

The primary benefits include transferring the financial risk of litigation to the funder, preserving the claimant's capital for core business operations, and enabling access to justice for meritorious claims that might otherwise not be pursued due to prohibitive costs. It can level the playing field between parties with unequal financial resources⁴, ⁵.

What are the potential downsides of third-party funding?

Potential downsides include the funder taking a significant share of any recovery, concerns about the funder's influence over the litigation strategy, and ethical questions regarding attorney independence and conflicts of interest. The lack of universal transparency can also be a concern¹, ², ³.