The third-party funding debate - we look at the risks

In this article we set out the debate over third-party funding. We look at the concerns that are commonly raised and suggest how parties can best minimise risks associated with funding.

The benefits of third-party funding are well known. Funding can provide access to justice for under-resourced parties (as is often the case in investor–state disputes) enabling them to pursue proceedings which a lack of financing would otherwise have prevented. For parties that are adequately resourced, funding can offer a more convenient financing structure, allowing capital which would otherwise be spent on legal fees to be allocated to other areas of their business during the proceedings. Against those benefits, however, there are concerns expressed about funding and there is a level of risk involved. Clear insight into potential downsides and sufficient risk preparation are therefore essential elements of making a decision on funding.

Unmeritorious claims

Could funding give rise to an increase in unmeritorious claims? In our view, it is more probable that the opposite could happen. Funding arrangements are more likely to act as a control on unmeritorious claims. Because their return is dependent on the success of the case, funders have no desire to take on weak – let alone unmeritorious – cases. They conduct due diligence on each case, weighing the merits of the parties’ respective claims and the likelihood of recovery before deciding whether to make an offer of funding. Parties may even benefit from this further analysis of the merits of their case (in addition to that already conducted by their legal advisors) – particularly where funders have seasoned arbitrators on their review boards.

The high cost of funding

If a party is successful, most funders will expect to recoup the sum funded plus a substantial fee – this can be a percentage of the damages recovered (often 20 to 40 per cent), a multiple of the amount advanced by the funder, or a combination of the two. That said, if a party would be otherwise unable to pursue proceedings without funding, recovering 60 per cent of the claim may be better than nothing.

There can be significant upfront costs of putting third-party funding in place. A party’s legal team must conduct due diligence on funders, put in place confidentiality agreements and then draft a bespoke funding agreement (this is necessary, given the terms will vary depending on the parties and the case). Some or all of these costs may be wasted if an offer of funding is not made. Similarly, where multiple funders have been approached. However, some funders will agree to back roll funding to cover these costs – this is a point to consider when negotiating with the funder.

In addition, parties that have obtained third-party funding are often vulnerable to a security for costs application, which, even if unsuccessful, can drive up the costs of the proceedings. The existence of funding can be a factor which the tribunal will consider in making its decision on such an application – although it will not be the sole determining factor.

Recovery of costs against funders

In English litigation, a third-party funder of an unsuccessful litigant may be liable to contribute towards the costs of the other side, though currently such contribution is limited to the amount of funding provided. In the context of arbitration, the outcome is not quite as simple – the tribunal may not have jurisdiction to make a costs award against a funder, given that it is unlikely to be a party to the arbitration agreement. Whether the tribunal has jurisdiction will depend on the procedural law and rules governing the particular arbitration. Either way, if an unsuccessful party is unable to meet an adverse costs award/order, the successful party may find itself unable to recover the full amount from the funder (or indeed any of the sum owed). A party whose opponent is funded should therefore consider whether to make an early application for security for its costs.

Conflicts of interest

Third-party funding arrangements may result in undisclosed conflicts of interest – perceived or actual. This can occur, for example, where there is a prior relationship between the funder and a party or law firm involved in the proceedings or between the funder and an arbitrator. Such conflicts can result in costly satellite disputes, including challenges to the arbitrator’s appointment and applications for disclosure of funding arrangement. Parties seeking third-party funding should consider whether they should disclose those arrangements (and if so, how and when). Again, the applicable law and rules of the arbitration will play a determinative role here.

Confidentiality and privilege

Rules of privilege vary across jurisdictions, as do approaches to the confidentiality of arbitration. In advance of entering into correspondence with third-party funders, these issues must be considered under all applicable laws. Failure to do so risks having to later disclose such communications – which often contain confidential or privileged material. Parties should enter into confidentiality or non-disclosure agreements with prospective funders. Parties should also consider what material in fact needs to be shared: a balance must be struck between limiting risk and meeting the funder’s need for adequate information (both when considering whether to make an offer for funding and throughout the proceedings).

Improper influence over proceedings

Maintenance and champerty are historic common law rules barring third parties with no legitimate interest in the proceedings from supporting or maintaining proceedings in return for a share of the proceeds. In jurisdictions where these rules still apply, third-party funding is prohibited.

But even in jurisdictions where there is an increasingly relaxed attitude to these doctrines, there can be concerns over the influence funders may have over proceedings. As a funder has a direct financial interest in the outcome of a dispute, there is a risk that it might seek to interfere with the conduct of the proceedings. It is easy to see where tensions could develop – for example, if it is in a funder’s interest, it might pressure a party to agree to settlement even if this is not in the party’s best interest. Another concern is that, if the terms of the funding agreement allow, a funder might simply withdraw funding upon limited notice, leaving the party unable to continue the arbitration. To avoid these issues, the funding agreement should ensure that the funder does not have excessive control and may not unreasonably withdraw funding.

Is regulation the answer?

In the main, there is currently little to no mandatory regulation of third-party arbitration funding, whether in domestic laws, international conventions or the rules of the major arbitration institutions. In England – one of the largest funding markets alongside the US, Australia and Germany – a voluntary Code of Conduct for Litigation Funders has been in existence since 2011 and covers capital adequacy requirements for funders as well as rights to terminate or control proceedings. The Association of Litigation Funders is the body responsible for overseeing this self-regulation. However, currently only seven funders are members of that association, leaving a large proportion unregulated. This poses real questions over the viability of self-regulation.

The Queen Mary University of London 2015 International Arbitration Survey reported that a significant majority of respondents (71%) thought that third-party funding required regulation.¹ This may be a reflection of the fact that a lack of mandatory regulation puts a greater burden on parties – both those seeking funding and those facing a funded opponent. A party seeking funding must undertake due diligence on its funder (for example, to ensure that it has adequate available capital to meet the cases in its portfolio) and carefully negotiate the funding agreement. A party facing a funded opponent is often obliged to incur costs protecting its position with regards to recovery of costs. These additional burdens come at a time when parties are often under significant pressures – time, financial and business.

The international arbitration third-party funding market has to date operated adequately without mandatory regulation. But given the increase in cases that are funded, the number of new funders entering the market and the globalisation of the industry (many funders operate across multiple jurisdictions), there may be grounds for the introduction of external regulation. A number of jurisdictions and arbitration institutions are considering just this issue. The concern, however, is that different standards could be set in different jurisdictions and under different arbitral rules. It would be far preferable – for parties and the funding industry – to have minimum common standards. The question is what that would look like and how that could be achieved.