Abstract
Proponents of third-party litigation funding argue that it is socially beneficial, helping parties bring meritorious litigation that otherwise would not be possible, due in part to the ability of the plaintiff to share risk with funders. But the reality of how some third-party funding contracts are structured belies this theory. Many such contracts include “waterfall” clauses whereby funders get paid back first upon successful case resolution. This leaves most of the risk on the plaintiff, the party usually least equipped to bear it. This is at odds with the prescription of standard economic theory, which suggests that the residual claimant should be the party best able to manage risk, in this case, the litigation funders.
We introduce a simple, numerical model that captures this intuition and shows why “equity” contracts would be preferred by risk-averse plaintiffs. Moral hazard, adverse selection and funder agency costs likely all play a role in why waterfall contracts are used. We suggest three simple changes to funding arrangements that could ameliorate this situation. Counterintuitively, giving lenders greater power by allowing them to have input into settlement negotiations could lead to different contractual setups that shift the risk more to the litigation funders.
Recommended Citation
David S. Abrams & Tom Baker, Don’t Go Chasing Litigation Funding Waterfalls, 2025 ULR 965 (2025).