It was David fighting Goliath. Miller UK Ltd., a small business, sued Caterpillar, a Fortune 500 company, for misuse of trade secrets. Throughout the 2010 lawsuit, Miller accused Caterpillar of using its superior resources to suppress the lawsuit; Caterpillar’s revenue exceeded Miller’s revenue by over 50,000%. To fight back, Miller relied on litigation financing, a practice in which a third-party firm provides capital in exchange for claims on future trial awards and settlement payments. Properly financed, Miller ultimately won a $74 million award in trial. Corporate plaintiffs like Miller have increasingly relied on litigation financing to afford rising legal costs. Litigation-financing firms invested $2.3 billion in U.S. lawsuits in 2019, roughly 10% of total spending by large U.S. corporations on outside counsel for litigation.

Legal practitioners disagree on the societal impact of the growth of litigation financing. Proponents argue that allowing plaintiffs and their attorneys access to capital corrects the traditionally unfair corporate litigation system, in which deep-pocketed defendants bully underfunded plaintiffs. As New York Supreme Court Justice Eileen Bransten wrote, “Litigation funding allows lawsuits to be decided on their merits, and not based on which party has deeper pockets.” In contrast, critics warn that an infusion of third-party capital serves only to increase the volume of litigation and payouts to lawyers. Similarly, the U.S. Chamber of Commerce claims that litigation financing encourages frivolous lawsuits that waste the defendant’s time and resources.

How should policymakers assess the merits of these competing arguments? Data on litigation financing and associated lawsuit outcomes are limited. Fortunately, even without data, economic theory provides a clear takeaway: Policymakers should encourage litigation finance in situations where well-funded defendants spend a great deal on legal representation. In contrast, in situations where defendants have fewer resources, litigation financing should be discouraged.

To understand this result, consider a setting in which a plaintiff firm files a lawsuit against a defendant firm. Both firms immediately face a choice: How much should they spend on legal representation? For the plaintiff, a more expensive lawyer can use better tactics to increase the expected trial award (i.e., the amount that the judge will require the defendant to pay if the plaintiff prevails at trial). Conversely, the defendant can spend more on lawyers to reduce the expected trial award it might have to pay the plaintiff. Importantly, while the defendant typically has deep pockets, the plaintiff often has limited resources to pay for lawyers. In this setting, litigation financing is a contract that provides funds to the plaintiff, allowing it to hire better and more aggressive lawyers in exchange for a share of any future lawsuit proceeds.

After both firms hire lawyers, the lawsuit proceeds to the discovery phase. New information arrives, leading to unpredictable changes in the expected trial award. The plaintiff and defendant now face a new decision: should they wait for a trial or settle the lawsuit, and when is the right time to settle? This settlement timing decision depends on the following tradeoff. Settling imposes a fixed reputation cost on the defendant: without knowing the trial outcome, stakeholders (e.g., customers and regulators) might assume the defendant has done something wrong, harming the defendant’s future business. However, if the lawsuit goes to trial and the defendant must pay a large trial award, that can be wasteful in other ways: the negative publicity of a large trial award could encourage future plaintiffs to sue the defendant. In this sense, the following strategy is the least wasteful way to handle a lawsuit: settle if and only if the discovery process reveals that the trial award will be large. This settlement strategy ensures that the defendant only pays the fixed reputation cost of settling when it is less costly than the expected fallout from a trial. Naturally, the plaintiff will go along with this settlement strategy at the right price: they will demand a settlement payment that lets them share in the benefit from the avoided trial.

This basic framework helps answer relevant policy questions: does litigation financing benefit the plaintiff more than it harms the defendant? Or is litigation financing socially wasteful in the sense that defendants lose more than plaintiffs gain? The answer to these questions has two components. First, this model reveals an obvious social downside to litigation financing. As financing becomes widely available, plaintiffs spend more on lawyers. As Figure 1 shows, this increased plaintiff spending increases expected trial awards. As trial awards grow, defendants lose more than plaintiffs gain because large public trial awards embolden future plaintiffs to sue defendants. Because of this effect, each additional dollar of expected trial award (the solid line in Figure 1) increases a defendant’s expected loss by more than one dollar (the dashed line in Figure 1). This one effect implies that policymakers should discourage litigation financing unless there is an offsetting benefit.

However, this model also reveals a subtle benefit to litigation financing: it discourages excessive legal spending by defendants. When a defendant expects a case to go to trial, it is willing to spend heavily on lawyers—say, ten million dollars—to reduce the expected payout by the same amount. That might make sense for the defendant, and it is certainly good for lawyers, but it is wasteful overall. Part of what the defendant loses in court ends up in the plaintiff’s hands. If the defendant spent less on lawyers and paid more to the plaintiff, they could jointly devote more resources to productive work, not litigation. Litigation financing helps make that happen. With better funding, plaintiffs can hire stronger legal teams, raising the expected trial award. That makes defendants more eager to settle since losing in court now looks costlier. And once settlement becomes likely, defendants are less motivated to overspend on lawyers—because they might avoid trial altogether. Figure 2 illustrates this point, the solid line reflecting the fact that defendant legal spending falls as the availability of litigation financing grows. 

What does this mean for policymakers? Litigation financing increases expected trial awards, which has a social downside (defendants lose more than plaintiffs gain in trials) and a social upside (a higher likelihood of settlement discourages the defendant from excessive legal spending). Therefore, policymakers should focus on deterring litigation financing in situations where the social upside is small. For example, a small privately held defendant is unlikely to have the resources to overspend on lawyers. A ban on litigation financing based on the defendant’s size (i.e., lawsuits targeting private defendants) could be beneficial. In contrast, policymakers might want to encourage litigation financing in lawsuits targeting large publicly traded defendants: those are precisely the firms that likely overspend on lawyers.