The incentive structure of litigation finance: How free coordination turns financed collective redress into an indispensable internalization tool

This paper cautions against the regulation of third-party litigation funding (TPLF) in the EU. TPLF is indispensable for enabling collective redress, which in turn is indispensable for internalizing externalities in a free market economy. Looking at the governance structure of TPLF more closely, we argue that contractual coordination and private incentives are sufficient to shape TPLF into a socially beneficial enabler of collective redress. TPLF achieves four things: First and foremost, it provides funds for projects that are excluded from equity markets as well as bank loans. Second, it allows for extreme specialization of the vehicle conducting the litigation aligning incentives with original claimants. Third, it reduces the costs of risk through diversification and, forth, it reduces agency costs arising from a conflict between original claimants and attorneys (which is reinforced by the regulatory suppression of contingency fees). TPLF achieves these things by two means. First, funders combine the skillset that allows them to price the project with access to capital markets. They essentially sell capital market access to litigation projects. Thereby they also shift risk away from the specialized vehicle to diversified funders, reducing the cost of risk and enabling the vehicle to specialize. Second, taking the funder on board attenuates the agency conflict between attorneys and original claimants by enlisting it as a designated monitor whose incentives are aligned with those of original claimants. As scenarios of harm remain hypothetical, we conclude that there is no need to regulate TPLF at this point.