Law Firm Portfolio Financing: A Primer On The Current State Of Ethical Considerations

Can law firms ethically take litigation funding secured by their anticipated fees?

Litigation funding generally comes in two varieties — funding to a claimholder or funding to a law firm.  Last year, an advisory ethics opinion by the New York City Bar Association called into question the propriety of providing funding to a law firm in certain circumstances.  Ethical concerns about litigation funding are already one of the main reasons that some attorneys shy away from litigation funding — so what is the current state of play?  Can law firms ethically take litigation funding secured by their anticipated fees?

ABA Model Rule 5.4(a), the widely adopted provision which addresses the “Professional Independence of a Lawyer,” contains a general rule that “a lawyer or law firm shall not share legal fees with a nonlawyer.” According to the comments to the model rule, “[t]hese limitations are to protect the lawyer’s professional independence of judgment” and “also express[ ] traditional limitations on permitting a third party to direct or regulate the lawyer’s professional judgment in rendering legal services to another.”

ABA Model Rule 5.4(a) does not preclude law firms from taking recourse funding on a fixed return basis from a litigation-finance company (or from a bank or other funding source). According to the New York City Bar Association, “the fee-sharing rule does not forbid a traditional recourse loan requiring the lawyer to repay the loan at a fixed rate of interest without regard to the outcome of, or the lawyer’s receipt of a fee in, any particular lawsuit or lawsuits.” This includes fixed return loans made with recourse to fees that have already been earned but have not yet been collected.

But the question becomes more complicated when the funding is nonrecourse — i.e., when the returns for the litigation-funding arrangement depend on the law firm’s ultimate success in specific matters and, if successful, the amount of fees earned. At Lake Whillans, we have seen inquiries for this type of law firm financing increase as firms seek ways to accelerate monetization of their contingent interests, meet current case needs, and enable firm growth and client acquisition. Realization of contingent fees can take years, and despite their successes, firms may have less cash than they would like or need to grow their business and pay their attorneys while waiting for contingent fees to be realized.

Because this type of funding has been in such high demand, in the litigation-funding industry it has been common practice to provide funding to law firms secured against a basket, or portfolio, of cases, rather than a single case, to avoid running afoul of ABA Model Rule 5.4. Although litigation funders like Lake Whillans have no right to control the cases funded as a matter of contract, tying returns to a basket of cases further ensures that funding does not appear to compromise an attorney’s independence and professional judgment.

One interpretation of Rule 5.4, called the “direct relation test,” posits that Rule 5.4 “intend[s] to bar any financial arrangement in which a nonlawyer’s profit or loss is directly related to the successfulness of a lawyer’s legal business.” Some legal ethicists consider earned but not yet collected fees to not implicate a business’s success, but consider that unearned contingent fees do depend upon the successfulness of the lawyer’s business. This distinction between lending against earned but uncollected fees and unearned contingent fees seems academic and ignores the reality that most businesses are permitted to secure financing based on expectations about future earnings. Courts have generally agreed that this is a distinction without a meaningful difference.

In a 2015 case, for example, a New York court rejected the argument that “a credit facility secured by a law firm’s accounts receivable constitutes impermissible fee sharing with a non-lawyer.” In that case, significantly, the agreement entitled the funder to a “percentage of the Law Firm’s gross revenue . . . essentially composed of contingent fees earned on client settlements and verdicts.” The court stated:

[C]ourts have expressly permitted law firms to fund themselves in this manner. Providing law firms access to investment capital where the investors are effectively betting on the success of the firm promotes the sound public policy of making justice accessible to all, regardless of wealth. Modern litigation is expensive, and deep pocketed wrongdoers can deter lawsuits from being filed if a plaintiff has no means of financing her or his case. Permitting investors to fund firms by lending money secured by the firm’s accounts receivable helps provide victims their day in court.

That decision came on the heels of another New York decision similarly finding such an agreement enforceable. That court similarly recognized the value of litigation-financing arrangements: “There is a proliferation of alternative litigation financing in the United States, partly due to the recognition that litigation funding allows lawsuits to be decided on their merits, and not based on which party has deeper pockets or stronger appetite for protracted litigation.” The court quoted a 1997 Delaware case “not[ing] that there is no suggestion that it is inappropriate for a lender to have a security interest in an attorney’s accounts receivable. It is, in fact, a common practice. Yet there is no real ‘ethical’ difference whether the security interest is in contract rights (fees not yet earned) or accounts receivable (fees earned) in so far as Rule of Professional Conduct 5.4, the rule prohibiting the sharing of legal fees with a nonlawyer, is concerned.”

A number of other decisions have likewise either summarily dismissed the idea that a financed law firm should be relieved of its obligations “under guise of ethics” or concluded that a lender had properly secured an interest in contingent fees without reaching the ethical question. There does not appear to have been any decision in which a litigation-financing arrangement for contingent fees has been held illegal or unenforceable due to alleged “fee splitting” concerns.

But a New York City Bar Association advisory opinion issued in July 2018 called the practice into question. The opinion noted that ethics opinions both from the New York City Bar and other bar associations have prohibited arrangements where, for example, a marketing service or landlord would be paid based on a percentage of a law firm’s revenues.

Rule 5.4(a) forbids a funding arrangement in which the lawyer’s future payments to the funder are contingent on the lawyer’s receipt of legal fees or on the amount of legal fees received in one or more specific matters. That is true whether the arrangement is a non-recourse loan secured by legal fees or it involves financing in which the amount of the lawyer’s payments varies with the amount of legal fees in one or more matters.

The opinion acknowledged that it appeared to be at odds with the New York courts that had found such arrangements enforceable but concluded that “New York courts could be expected to enforce the arrangements, because lawyers who violate the Rules cannot ordinarily invoke their own transgressions to avoid contractual obligations.” The opinion also acknowledged that its advice might be seen as “overbroad” but contended that, if so, the place for a remedy should be in the state judiciary or state legislature, which ultimately has authority to change the ethics rules.

The New York City Bar Association opinion has caused significant consternation among funders and attorneys. Ultimately, the New York City Bar established a “Litigation Funding Working Group” to address the “ethics rules and framework” related to the advisory opinion, current and best practices for litigation funding, and disclosure issues, among other topics. In establishing the working group — which includes NYU ethics professor Stephen Gillers and former SDNY Judge Katherine Forrest — the NYC Bar indicated it “will not be revisiting Opinion 2018-5, but is open to exploring potential revisions to the ethics rules and/or legislation.” It expects to issue findings by the end of 2019 and recently received comments from interested parties.

The vast majority of bar associations have not opined on this issue but the handful that have reached a similar conclusion to the NYC bar: Maine, Missouri, Nevada, North Carolina, Texas, Utah, and Virginia. Although many of these opinions predate the large-scale litigation funding industry, the basic idea is generally the same as the NYC bar precedents. The only bar association to have affirmatively approved of contingent financing appears to be Philadelphia, which found no issue with contingent, fixed-return financing because it “appears to be no different than when an attorney negotiates a loan from a bank to cover operating costs or as working capital.”

So where does this leave law firms seeking funding — particularly law firms that are seeking financing against a portfolio of cases?

• First, the New York City Bar Association advisory opinion is just that — advisory — and, while it may be persuasive should an ethics issue arise, it is not a prohibition on litigation financing of law firm portfolios. Ultimately, it is one effort at an interpretation of an ethical rule that is subject to multiple interpretations.
• Second, under New York law these funding agreements remain enforceable and legally valid providing peace of mind from that perspective both to the funder and law firm. We are unaware of any jurisdiction that has declined to enforce this type of funding agreement on the basis of the fee-splitting rule.
• Third, the ethical issue at stake is ultimately the independence of the attorney, and the attorney can ensure that such independence is not compromised both in practice and through terms in the funding agreement protecting attorney independence. Numerous ethics experts have opined that the distinction between prohibiting litigation funding based on a law firm portfolio and bank lending is illusory in this context. The NYC Bar opinion, according to Professor Anthony Sebok and Hinshaw & Culbertson Partner Anthony David, “creates distinctions between the loss of independence of lawyers who engage in traditional borrowing from their banks — where they place all of their receivables at the ultimate mercy of the ender if they default — and the supposed greater loss of independence where instead the lawyer borrows based on the results of specific cases, where the lender has no recourse if the cases fail to yield those results. Such an interpretation is, surely, absurd.”

Each firm must weigh the risks and benefits of seeking portfolio financing and seek outside advice if necessary.  While we view the NYC Bar opinion and those like it as ill-considered and overly formalistic, they are a reality with which a law firm seeking funding must be comfortable.  (Anecdotally, based on the inquiries Lake Whillans receives, the opinion has not stopped law firms from actively seeking portfolio financing in New York or elsewhere.)  The landscape continues to evolve and funders and attorneys alike hope that a more reasonable and realistic interpretation of Rule 5.4 prevails.  Until that consensus emerges, Lake Whillans and, we expect, other funders will work with law firms and their counsel to craft agreements that address their concerns and minimize risk.