In the US, the practice of commercial litigation funding is allowed in virtually every jurisdiction, as long as the transaction complies with existing ethical rules that govern attorneys. This chapter focuses on the commercial litigation financing market as opposed to the consumer litigation financing market, as these are effectively separate industries.

Historically, the common law doctrines of champerty and maintenance posed significant obstacles to litigation funding. Champerty prohibits third parties from providing financial assistance to a claimant in exchange for a share of the damages, while maintenance prohibits third parties from “intermeddling” with another's lawsuit. However, these doctrines have been significantly limited or abolished in most US states, particularly concerning commercial litigation funding. It is important to note that, while many states have relaxed or eliminated these doctrines, some jurisdictions may still have restrictions on champerty that could limit or prohibit certain litigation funding arrangements.

For a variety of reasons, including champerty and maintenance laws, litigation funders structure their financing as a passive investment with no control over the litigation strategy, disposition or other aspects of the attorney-client relationship.

Federal Regulations

There is no federal regulation that applies specifically to litigation finance. Efforts to impose regulation on the industry have focused almost entirely on mandating disclosure of the funding arrangement.

Currently, there is no nationwide requirement to disclose litigation funding agreements to courts or opposing parties in federal litigation. However, this lack of uniformity has led to a patchwork of state regulations and local rules, creating inconsistency and uncertainty for litigants and funders.

In response to growing concerns about transparency and potential foreign influence, several legislative efforts aim to establish federal disclosure requirements. The Litigation Transparency Act of 2024, introduced in the House of Representatives, would mandate the disclosure of parties receiving payment in civil lawsuits, including third-party investors and their financing agreements.

The Judicial Conference's Advisory Committee on Civil Rules formed a subcommittee in 2024 to evaluate the need for new federal rules governing the disclosure of third-party financing. This initiative, along with the proposed legislation, suggests a growing trend toward increased transparency and regulation of litigation funding at the federal level.

State Regulations

Several states have taken proactive steps to regulate litigation funding, focusing primarily on consumer protection and disclosure requirements. Montana, Indiana, Louisiana and West Virginia have enacted legislation mandating the transparency of funding agreements and holding funders accountable for financing frivolous lawsuits.

Some states have implemented specific regulations to protect consumers in litigation funding transactions, which are not applicable to commercial litigation finance. For example, New York's Consumer Litigation Funding Act aims to regulate the industry by establishing contract requirements, prohibiting excessive fees and deceptive practices, and requiring the registration and licensing of litigation finance companies.

Other state legislatures are currently considering the adoption of mandatory disclosure of litigation financing agreements, although these efforts face opposition from the litigation funding industry as well as large constituencies within the bar and business community that benefit from the availability of commercial litigation funding.

Aside from reputational considerations that promote considerable self-regulatory behaviour among funders, the commercial litigation finance industry has created a trade association called the International Legal Finance Association (ILFA). ILFA currently has approximately 20 members, which include most of the largest and most-established litigation funders.

This article focuses primarily on commercial litigation funding involving sophisticated parties who do not need or want regulations aimed at consumer protection. Consumer litigation funding (as opposed to commercial litigation funding), which involves providing financial assistance to individuals with personal injury or other claims, has attracted significant attention regarding consumer protection. Concerns arise from potentially high fees, aggressive marketing tactics and the vulnerability of consumers facing financial hardship.

Some states have implemented specific regulations to protect consumers in litigation funding transactions. For example, New York's Consumer Litigation Funding Act aims to regulate the industry by establishing contract requirements, prohibiting excessive fees and deceptive practices, and requiring the registration and licensing of litigation finance companies.

Commercial litigation financing agreements are legal and enforceable in virtually every jurisdiction in the US. As noted in 1.2 Rules and Regulations on Litigation Funding, there is currently no federal rule or law aimed specifically at litigation financing. However, largely by virtue of self-regulation, the overwhelming majority of litigation financing agreements explicitly set forth the funder’s role as a passive investor with no ability to control the litigation or interfere with the attorney-client relationship.

As noted in 1.2 Rules and Regulations on Litigation Funding, disclosure requirements for litigation funding agreements vary significantly across jurisdictions. While there is no universal federal mandate, some states and district courts have implemented specific rules.

Arguments for disclosure emphasise transparency, allowing courts and parties to assess potential conflicts of interest and ensure the integrity of the litigation process. Opponents argue that disclosure may be unnecessary and burdensome, potentially chilling the use of litigation funding and hindering access to justice.

The ongoing debate surrounding disclosure highlights the need for a balanced approach that promotes transparency while avoiding undue burdens on litigants and funders.

During the last decade, a significant body of case law has developed on the issue of the disclosure and discoverability of litigation financing documents, including the funding agreements themselves, as well as communications with funders. In the vast majority of cases, courts have ruled that litigation financing documents are not admissible either because they are irrelevant to the underlying litigation and/or because they are protected under the work product doctrine.

Unlike many other jurisdictions, the US generally does not follow the “loser pays” rule, where the unsuccessful party is responsible for paying the legal costs of the winning party. This regime significantly reduces the risk of adverse costs in US commercial litigation, making after-the-event (ATE) insurance less common compared to jurisdictions like England or Australia.

There are limited circumstances where US courts may order a party to provide security for costs, such as when seeking a preliminary injunction. Otherwise, parties are generally not required to provide security.

While ATE insurance is not prevalent in the US due to the absence of the “loser pays” rule, other forms of insurance play a crucial role in managing litigation risk. Companies routinely utilise insurance to defend and indemnify themselves against legal claims, protecting against the financial burden of potential adverse judgments.

Furthermore, specialised insurance products have emerged to address specific litigation risks. Contingent risk insurance offers various options, including adverse judgment insurance for defendants and contingent fee insurance for law firms, providing downside protection against specific litigation outcomes.

Types of Contingent Risk Insurance

Contingent risk insurance encompasses a range of products designed to address specific litigation risks. Key types include the following.

• Judgment Preservation Insurance (JPI) protects plaintiffs who have won at trial from the risk of a reversed or reduced judgment on appeal. It allows plaintiffs to secure a portion of their award while the appeal is pending, providing financial certainty and potentially facilitating settlement negotiations.
• Adverse Judgment Insurance (AJI) protects defendants from the financial risk of an adverse judgment. It can be particularly useful in situations where a company is facing a high-stakes lawsuit with the potential for a significant financial loss.
• Contingent Fee Insurance protects law firms that are working on a contingency fee basis from the risk of not receiving payment if the case is unsuccessful. It can help law firms manage their cash flow and take on cases with a higher risk profile.
• Capital Protection Insurance protects litigation funders from the risk of losing their investment if the case is unsuccessful. It can help encourage funders to invest in a wider range of cases, potentially increasing access to justice.

Contingency fee arrangements have long been a fundamental aspect of the US legal system, and are commonly used to finance commercial disputes. Other types of alternative fee arrangements (AFAs) include fixed fees, deferred fees, success fees, capped fees and hybrids of any of these options. A common AFA in commercial litigation finance is a hybrid contingent-hourly fee arrangement, whereby the law firm may receive 50% of its fees as incurred and, in exchange for deferring the other 50%, receives a contingent fee interest in any recovery proceeds.

In the US, each jurisdiction establishes its own ethical guidelines, opinions and case law to define the permissible scope of contingency fees. These guidelines are generally grounded in Model Rule of Professional Conduct 1.5(a), which requires that fees be reasonable. Model Rule 1.5(c) further mandates that contingency fee agreements be documented in writing and signed by the client, and include a detailed explanation of how the fee will be calculated, along with any expenses the client may need to cover.

Fee sharing between lawyers and litigation funders is a significant ethical concern. Rule 5.4(a) of the Model Rules of Professional Conduct prohibits lawyers from sharing legal fees with non-lawyers. This rule is intended to protect the independence of lawyers and to prevent non-lawyers from influencing legal decision-making.

In the context of litigation financing, fee sharing arrangements can arise when a funder provides financing to a law firm in exchange for a portion of the firm's contingency fee. Such arrangements may violate Rule 5.4(a) if the funder's return is tied directly to the amount of the lawyer's legal fees. However, if the funding agreement is structured properly, it should not violate Rule 5.4(a) in virtually every jurisdiction.

Several ethics opinions and court rulings have addressed the issue of fee sharing in litigation financing arrangements. In 2018, the New York City Bar Association's Professional Ethics Committee concluded that a litigation funding agreement between a funder and a lawyer, where the lawyer's future payments to the funder are contingent on the lawyer's receipt of legal fees, violates Rule 5.4(a). However, in 2020 the New York City Bar Association’s Working Group released a report advocating for changes to Rule 5.4 to facilitate access to litigation funding.

Non-lawyer ownership of law firms is generally prohibited in the US. A notable exception is the state of Arizona, which recently abolished the prohibition of fee sharing with non-lawyers (Rule 5.4) and adopted a regime that allows law firms to structure themselves as an alternative business structure (ABS). ABSs are a relatively new development in the US legal market and allow non-lawyers to own or invest in law firms and share in legal fees. Currently, Arizona, Utah and the District of Columbia are the only states that explicitly allow some form of fee sharing with non-lawyers.

The emergence of ABSs has implications for litigation financing. ABSs can facilitate litigation financing by allowing non-lawyer investors to provide capital to law firms engaged in litigation. This can increase access to justice by providing funding for law firms that might not otherwise be able to afford to take on certain cases. However, ABSs also raise ethical concerns, such as the potential for non-lawyers to influence legal decision-making and the need to ensure compliance with professional standards.

Generally, legal fees are deductible if they are ordinary and necessary expenses incurred in carrying on a trade or business or for the production of income. However, there are limitations and exceptions to this general rule.

Tax Implications for Funders

In addition to the tax implications for litigants and law firms, commercial litigation funding also has tax consequences for funders. The characterisation of a funder's return as ordinary income or capital gain depends on how the funding arrangement is treated for tax purposes.

If the funding arrangement is treated as debt, the funder's return will generally be considered interest income, which is taxed as ordinary income. If the arrangement is treated as equity, the funder may be considered a partner in the litigation and will be taxed on its share of the partnership's income.

If the arrangement is treated as a derivative, the funder may be able to argue that their return is a capital gain under Section 1234A of the Internal Revenue Code. This section provides that gain or loss from the sale or exchange of a capital asset that is a “notional principal contract” (which can include certain types of derivatives) is treated as capital gain or loss.

Tax Treatment of Litigation Funding Proceeds

The tax treatment of litigation funding proceeds in the US is complex and often depends on how the funding arrangement is structured. Achieving the desired tax outcome requires careful structuring of the funding arrangement, as different structures can lead to different tax consequences. There are two primary ways to structure litigation funding: as a loan or as a sale.

Loan Arrangements

In a loan arrangement, the funder provides an advance to the litigant or law firm, which is repaid with interest if the litigation is successful. Loan arrangements have the advantage of deferring any tax on the receipt of the initial funding. However, there can be tax downsides later. If the funding is structured as a loan but does not meet the requirements of a loan under tax law, the IRS may treat the proceeds as taxable income in the year received.

In determining whether an advance constitutes a loan for tax purposes, courts consider several factors, including whether:

• there is a valid and enforceable obligation to repay;
• the obligation to repay is unconditional or contingent on the outcome of the litigation;
• there is a written promissory note or other evidence of indebtedness;
• there is a reasonable rate of interest and a fixed maturity date; and
• the parties intended to create a debtor-creditor relationship.

Sale Arrangements

In a sale arrangement, the funder purchases a portion of the potential recovery in the lawsuit. While some funders may avoid using the term “sale”, many litigation financing documents are written as sales. When the parties opt for a sale, funders will typically document their investment as a prepaid forward contract. This allows the recipient to defer reporting the funder's advance as income until the conclusion of the case. However, the contract must meet certain requirements to qualify as a prepaid forward contract.

When a US taxpayer makes payments to a foreign person or entity, withholding tax may be required. This can be a significant cost for US taxpayers who make payments to offshore funders and a crucial consideration in commercial litigation funding, as many funders are based in offshore jurisdictions.