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Third-Party Litigation Financing and Ethical Traps for the Unwary Lawyer

by Luke Sbarra |

Third-party financing of personal injury litigation presents myriad ethical issues for an attorney working with a third-party financier (“TLF”) in the context of personal injury litigation. This type of financial arrangement generally involves a contract between a plaintiff and a funding entity providing the TLF with an assignment in an interest in the proceeds from a cause of action. This assignment differs from the assignment of a claim, as the latter is void and against the public policy of the State of North Carolina because it is a champertous contract.  See, e.g., Charlotte-Mecklenburg Hosp. Auth. v. First Georgia Ins. Co., 340 N.C. 88, 455 S.E.2d 88 (1995).  TLF funding arrangements often present attractive opportunities to personal injury plaintiffs whom are otherwise without means to finance the cost of litigation, living needs, the cost of medical bills, or the expenses of litigation. Other plaintiffs without an urgent cash need may seek monetization of a future, contingent right of recovery through a TLF’s immediate cash offer in exchange for an assignment of unrecovered claim proceeds.  In another variation of TLF financing, which the North Carolina State Bar discussed in-depth in 2006 FEO 12, a TLF will fund a law firm’s expenses of prosecuting a civil cause of action.  Institutional TLFs entities also occupy a share of the commercial market financing commercial litigation for borrowers seeking funding to prosecute or defend commercial claims.

However attractive, and regardless of the utility of TLF loans, these financial arrangements are often laced with practical and ethical issues North Carolina attorneys should consider before, during, and while a client or attorney interfaces with a TLF.  Many of the ethical “pitfalls” potentially befalling an unwary attorney stem from the very nature of the TLF-client contract as a vehicle to provide funding for litigation.   Indeed, as a starting point, many TLF entities invariably insist on a “return” on investment in an amount much greater than the initial cash loan from the TLF to the plaintiff.  This will often lead to an unhappy client, faced with the prospect of little or no recovery after settlement or judgment and re-payment of the TLF and attorneys’ fees.  Odell v. Legal Bucks, LLC, 192 N.C.App. 298, 665 S.E.2d 767 (2008), discussed the right of a TLF to seek a recovery in gross disproportion to the original loan, and the incentives created thereby.  In addition, the terms of a TLF loan requiring a return of capital in gross disproportion to the original loaned amount, may discourage a plaintiff from considering any settlement or may force such a plaintiff to instruct counsel to disburse settlement funds in violation of the TLF’s contractual agreement with the plaintiff.  The latter scenario exposes the attorney to suit from the TLF, and occurs with some frequency even though such an action is typically meritless because the attorney is obeying an instruction from his or her client, is not a fiduciary of or to the TLF, and is not in contractual privity with the TLF.

The duties and concomitant ethical traps befalling lawyers in the TLF context depend somewhat on whether the TLF is funding the lawyer’s litigation expenses to prosecute a cause of action on behalf of a client or directly funding the client. TLF financing of a lawyer’s expenses to prosecute a personal injury lawsuit are permissible, provided, however, that the financier’s practices are lawful and the TLF loan is not contingent upon the lawyer’s willingness to give the TLF a lien on the client’s recovery. See 2006 FEO 12.    Counsel may, however, provide the TLF a lien on any recovery (as opposed to the expenses to fund the recovery) in an amount greater than the loaned amount in an exchange for a loan, as long as counsel has obtained written, informed consent from his or her client, the loan is not clearly excessive, and counsel will use the funds exclusively for litigation-related expenses. Counsel considering the legality of a TLF loan and whether the loan is excessive should read Odell and the statutes cited therein.

When a TLF makes a loan directly to a plaintiff and a plaintiff absconds with the settlement proceeds reneging on a contractual obligation to the TLF, counsel’s ethical duties are manifold, particularly if the TLF contract created a security interest or valid legal assignment of the rights to the proceeds.  First, counsel has an obligation to make a determination under applicable law (frequently involving a choice of law determination) as to the legality of the TLF contract, to advise the client of the consequences of breaching the contract with the TLF, and/or to refer the client to other counsel to discuss the foregoing issues.  In addition, to the extent the TLF contracts create a security interest or valid legal assignment and counsel’s client does not desire to re-pay the TLF, counsel should hold the disputed funds in counsel’s trust account until the dispute with the TLF is resolved, a court orders disbursement, or the attorney interpleads the funds.  See 2000 FEO 4.

A conflict of interest may arise under Rule 1.7(a) (2) if a lawyer has a relationship with a TLF interfering with counsel’s ability to provide impartial, unbiased advice to a client.  For example, although outright referrals fees are prohibited (99 FEO 1), the repeated involvement of a TLF in a lawyer’s legal engagements has the potential to create a conflict of interest for a lawyer as the lawyer may be perceived as subordinating the loyalties of his or her client to the interests of the TLF.  Further, although not strictly a conflicts rule, a client must be free to terminate representation without restriction.  Any agreement between a TLF and lawyer purportedly giving the TLF veto power over a client’s right to terminate counsel is inconsistent with Rule 1.16(a).   Finally, Opinion One in 2004 FEO 4 contains a thoughtful discussion of counsel’s obligation to exercise independent professional judgment on behalf of a client, uncluttered and uncompromised from any intermeddling of the TLF.

Similar to the pure conflict issues that crop up under Rule 1.7., Rule 5.4(c) contains an important prohibition preventing a TLF, as a payor of the legal services of counsel, from directing or regulating the lawyer’s professional judgment.  Moreover, the TLF as payor of counsel’s litigation expenses raises an issue as to whether counsel is compromising her duty of loyalty to the client to the payor of his legal expenses, the TLF. Accordingly, when a TLF is funding a lawyer’s expenses, counsel must not give priority to the demands of a TLF over the interests and objectives of a client.  One example of a TLF excessively regulating counsel’s conduct occurred in a Florida case, in which a TLF had the authority to approve the filing of a lawsuit, controlled the selection of claimant’s counsel, recruited fact and expert witnesses, received, reviewed, and approved counsel’s bills, and had veto authority over any settlement agreements.  See Abu-Ghazaleg v. Chaul, 36 So.3d 691, 693 (Fla. Dist. Ct. App. 2009).

Furthermore, regardless of whether a TLF contracts with a law firm or with a plaintiff, counsel must ensure that no confidential information acquired during the course of a professional relationship is disclosed to a TLF without the client’s informed consent.  Although the TLF may require information necessary to conduct its own due diligence, the attorney cannot provide to the TLF confidential information acquired during the course of a professional relationship.  Furthermore, regardless of any contrary provision in a TLF contract or request from a TLF, counsel must make the client aware of the any potential adverse consequences stemming from the dissemination of confidential and/or privileged information, including waivers of the attorney-client evidentiary privilege and the work-product privilege. A TLF will naturally want to know as much as possible about the status of a case and the likelihood of a favorable settlement or judgment on a verdict, considering the TLF will not recover if the plaintiff does not recover at least some portion of the extended credit.  The natural tendency of a TLF to stay informed about the status of a case is in direct tension with the lawyer’s duty of confidentiality owed to a client.  The duty of confidentiality cannot be jeopardized for the sake of advising a TLF regarding a loan.

Third-party litigation financing is an evolving and growing means of financing a contingent loss or commercial litigation, and this industry will continue to entice both plaintiffs and counsel and a growing segment of the commercial market.  Practitioners dealing with these financiers should be mindful of the latent ethical risks present in this type of financial arrangement. Click here for a sample checklist of issues.

About the Author

Luke Sbarra

Luke Sbarra is a Partner at Hedrick Gardner Kincheloe & Garofalo LLP in Charlotte, NC.  His practices focuses on professional liability, premises liability, construction defect, and commercial litigation.  He is the 2015 Chair of the Lawyers’ Professional Liability Committee of the Professional Liability Defense Federation and is listed in the North Carolina Rising Stars list, published nationwide in Super Lawyers Magazine, in 2010- 2015.

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