Third-party funding in a sequential litigation process

Third party litigation financing (TPF)—for-profit, nonrecourse funding of litigation by a nonparty—is a new and rapidly developing industry. As a novel phenomenon that involves various normative concerns, TPF has sparked much debate and controversy among scholars and policy-makers, speculating about its potential effects on issues such as the volume of litigation and the quality of claims filed. We develop a game-theoretic model that compares a litigation process with TPF and a “traditional” scheme in which litigation is self-funded. Under the TPF scheme, we decompose the litigation decisions into two parts: the plaintiff is in charge of the legal decisions, while the TPF has the freedom to decide in each stage of the litigation process whether to continue the financial support in the litigation process. Such a setting is characterized by a high level of uncertainty and a degree of asymmetric information between the plaintiff and the TPF. We argue that the divergent interests of the parties to the financing agreement can be aligned by constructing a viable contract that results in the same equilibrium outcome as litigation with no TPF. The contract that achieves these desired results has a few interesting properties. First, it provides a pre-specified remedy to the plaintiff if the TPF funder terminates the financing prior to the conclusion of the litigation process. Second, the contract also specifies the compensation to the TPF funder, which is due upon completion of the litigation process, and it is conditioned upon the awarded verdict.