The Shifting Landscape of Litigation Funding and Regulatory Risk: What COLPs and COFAs Need to Know

In recent years, litigation funding has emerged as a transformative force in the legal industry, initially celebrated for broadening access to justice. However, the narrative is shifting. Litigation funders are increasingly viewed as profit-driven entities, selectively backing high-return cases. This evolving perception—moving from "champions of justice" to "profit-seeking enterprises"—has drawn the attention of regulators and legal professionals alike.

This regulatory scrutiny is particularly critical for law firms engaged in mass or bulk litigation. These firms must be vigilant in managing compliance risks, especially those heavily reliant on third-party funding. For COLPs and COFAs, this necessitates a thorough reassessment of funding sources, contingency planning, and ensuring that their practices withstand regulatory examination. Let's delve into the emerging landscape and the key areas firms must address.

The Risks of Profit-Driven Litigation Funding

Litigation funders, once seen as allies in championing justice, now face growing criticism. Regulatory bodies are focusing on bulk litigation and the financial stability of funders, questioning the dependency on profit-driven third-party funders. While funders provide crucial resources for extensive litigation, their financial hardships or insolvencies could leave dependent firms vulnerable, burdened with substantial debt obligations at short notice.

Key Questions for COLPs and COFAs:

• What is your firm's contingency plan if a funder becomes insolvent?

• Could your firm remain stable without third-party funding?

• What financial reserves and credit arrangements do you have in place for sudden repayment demands?

• Where is the line between being profit-driven and exerting undue influence?

• What are the costs associated with the funding, and who bears them?

If these questions seem unfamiliar or challenging, it's imperative to conduct a comprehensive risk assessment, including worst-case scenarios. Due diligence must be an ongoing process, supported by meticulous documentation to ensure both compliance and long-term stability.

Regulation of Litigation Funding

Although the Financial Conduct Authority (FCA) regulates certain aspects of funders' activities—particularly those involved in investment management—litigation funding itself remains largely unregulated. This regulatory gap leaves room for vulnerabilities, especially concerning anti-money laundering (AML) compliance, with funders using offshore financing vehicles posing additional risks.

 Key Areas of Concern:

• Cross-Border Complications:  The international operations of many litigation funders complicate the enforcement of domestic AML laws.

• Non-Regulated Entities:  Funders not affiliated with the Association of Litigation Funders (ALF) or outside FCA's regulatory scope may evade stringent AML regulations, heightening the risk of money laundering.

Due Diligence on Funding Sources: Safeguarding Your Firm and Clients

The intensified scrutiny on litigation funding mandates law firms to go beyond a funder's reputation. Even when partnering with reputable commercial funders, COLPs and COFAs must undertake several critical steps to mitigate regulatory and financial risks.

Focus Areas:

• Source of Funds: Ensure funders are reputable and aligned with your firm’s ethical standards. Transparency in the origins of funds protects the firm and assures clients of your commitment to integrity.

• AML Processes: Verify robust AML measures are in place. Lack of diligence in this area could expose the firm to ethical and legal risks.

• Ongoing Reviews:  Regularly reassess the financial health and ethical standards of funders. Documenting each stage of due diligence is essential for regulatory reviews, demonstrating your firm’s commitment to ethical funding and proactive risk management.

The Vulnerability to Money Laundering with Third-Party Litigation Funding

Litigation funding involves significant capital, often from international private equity, hedge funds, family offices, institutional investors, or high-net-worth individuals. This vast and often international financial landscape makes litigation funding susceptible to misuse for money laundering.

 Key Risks:

• Opaque Funding Sources: The origin of funds used by litigation funders is often not transparent, increasing the potential for illicit capital infiltration.

• Complex Financial Structures:  Funders may operate through multiple entities, complicating the traceability of funds and adding to the risk of misuse.

Recent Events Shaping Regulatory Views

High-profile cases have exposed vulnerabilities in current regulatory frameworks. The SRA's intervention in Axiom Ince, for example, revealed significant oversight failures, prompting a shift toward more preventative measures. The SRA’s statement highlights the need for better data utilization to spot risky patterns, particularly in volume claim-based litigation funded by third parties.

Staying Ahead: Proactive Steps for Firms

With the likely introduction of more formal regulatory measures, proactive preparation is crucial for COLPs and COFAs. Steps include:

• Enhancing Due Diligence:  Implement rigorous checks on funders, including regular evaluations of their financial health and the origins of their capital.

• Transparency with Clients:  Clearly disclose funding details and potential influences on settlement decisions to clients.

• Internal Compliance Policies:  Develop and document best practices for working with third-party funders, ensuring adherence to ethical standards.

• Financial Contingency Plans:  Prepare for potential funder withdrawals or insolvencies by diversifying funding sources and establishing financial reserves.

• Engaging in Industry Conversations:  Stay informed through industry discussions and regulatory updates.

Reg Flag

It may sound like stating the obvious, but a common issue often neglected by many (as recent decisions have highlighted) is that third-party litigation funding is specifically for the cost of running a case and not for expansion plans, project financing, or wages. Any funding facility agreements entered into should be approved by a board resolution, specifying the intended use of funds, and not deviated from for obvious reasons.

By adopting these measures, firms can navigate the evolving landscape of litigation funding, ensuring compliance and financial stability in the face of emerging regulatory challenges.

Conclusion

Although third-party litigation funding has indeed created ‘Access to Justice’ as it was intended to, it is the case that after spending a significant period of time as an open playing field, formal regulation may be on the horizon. As compliance professionals, it must be remembered that although the industry itself may not be regulated, we as legal professionals are—and we must ensure that we do not fail in our regulatory duties.