The Myths and Realities of Third-Party Funding in Investment Arbitration
Keywords: third-party funding, frivolous, control rights, self-regulation, payment, costs, conflicts of interest.
Introduction
The market tends to find ways to satisfy its own needs. The significant expenses involved in taking a dispute to arbitration gave rise to third-party funding (‘TPF’), which is nothing other than the response of the financial and legal industries to the challenge of facilitating access to justice. By this, we do not refer exclusively to claimants that cannot afford a good and consistent legal defense throughout the arbitration proceedings, but also to those who just do not want to risk their own capital on litigation.
The main concerns regarding TPF
TPF introduces a new player with a direct interest in the result of the proceedings in the traditionally three-party system (investor-state-tribunal) that is investment arbitration. This has raised concerns among practitioners and academics, thereby prompting the question of whether TPF should be formally recognized and regulated or, on the other hand, eliminated.
The main issues raised regarding TPF are addressed in detail below.
Increase in frivolous claims
The opponents of litigation funding argue that the first cognizable impact of allowing TPF is the increase in frivolous claims. It is argued that an additional actor with an incentive to litigate automatically generates an increase in claims, potentially saturating the arbitration market, generating an escalation in litigation expense for host States, and adding a perverse incentive to arbitrators to accept more claims based on frivolous arguments and stretched interpretations because more the cases, more the fees for them. [1]
However, this would not make economic sense from the funder’s perspective, who is nothing but an investor assessing the risk of its investment step-by-step, based on the probability of a favorable outcome. There is no economic or reputational incentive for a funder to sponsor a blatantly frivolous claim, making this concern more of a myth than a reality.
When a potential claimant seeks to engage a third-party funder, the first step the funder takes is a know-your-client due diligence under which the potential claimant’s reputational risk is assessed. This creates a filter to reduce the risk of corruption or other criminal charges and ensures that the claimant will not bring a reputational burden to the funder. Second, the claim must meet a minimum quantum requirement, which prevents immaterial claims from being financed and brought forward. As a third step, the funder analyzes the potential profitability of the case against the amount to be financed. This risk-profit relationship constitutes a third important filter given that the funder will scrutinize the claim using not the amount of the potential claim, but the amount that the funder deems the tribunal could realistically award the plaintiff in the event of success. This more objective analysis brings down to earth the plaintiff’s expectations, which are usually raised by the optimism of the lawyers or their economic incentive to litigate the case.
Only once these three steps are met, the funder conducts more thorough due diligence of the facts, potential arguments, the evidence available, among other factors, avoiding getting involved in any claim that is doomed to fail.
As shown, the use of TPF involves additional filters in the decision of submitting an arbitration claim. [2] However, even if the availability of TPF could generate frivolous claims, it is the tribunals’ duty to make that decision and sanction it when deciding on the allocation of costs, creating an additional disincentive. The sole possibility of misuse of a device does not mean the device must be eliminated.
Conflicts of interest
Another criticism levelled at TPF is its ethical aspect, based on the potential conflicts of interest that may be present. A conflict of interest exists with respect to an arbitrator when “relevant facts and circumstances, would give rise to justifiable doubts as to the arbitrator’s impartiality or independence”. [3]
TPF is also subject to the same standard with respect to conflicts of interest. This means that the arbitrators must also be impartial and independent in the context of the funder. This was acknowledged by the UNCITRAL Working Group III during the thirty-seventh session. [4] Nevertheless, the said concern is shared by the funders as well. The litigation funder is equally interested in avoiding conflicts of interest, as it has a strong motivation to ensure that a successful award is not annulled due to said conflict. Therefore, the funder carries out its own conflict check before beginning any relationship with the future claimant. The funder’s incentive to avoid conflicts of interest is aligned with this goal.
To date, no award has been annulled in investment arbitration due to a failure to disclose a conflict of interest of a third-party funder. The concern is mostly academic because in practice the parties have been successful at self-regulating and avoiding conflicts of interest.
Control rights of the Third-Party Funder
The level of involvement of the third-party funder in the control and decision-making process during the formation and course of the arbitration often depends on the percentage of the litigation costs that are being funded by the funder. In a similar sense to equity holders in a company, a minority shareholder will have a weak or non-existent position in the control of the company and is only interested in his or her year-end returns. The greater the amount finance, greater the involvement requested by the funder in its contract with the claimant.
The opponents to third-party funding object to this potential control. In different stages of the arbitration, the interests of the claimant and the funder may not be the same, as they might disagree on the appointment of arbitrators, the amount of the claim, the use of certain arguments or evidence, or the strategies employed to pursue the claim. [5] In the course of the proceedings, a litigation funder may want the client to accept what it regards as a reasonable offer of settlement, but the client wishes to pursue the matter. [6] Even at the end of the arbitration, there might be a disagreement regarding when and how the award must be enforced.
However, these scenarios must not be regulated in laws or treaties, but by the parties. The influence of a funder in the decisions with respect to the litigation does not differ from the influence that a new board of directors or new controlling shareholder could exert over the litigation strategy, with which the management of the company may or may not agree. Why should one be regulated and not the other? In any event, claimants are free to decide on what factors go into their internal decision-making process and the weight they attribute to the conflicting interests of their stakeholders.
Security of costs or payment of counterclaims
Most bilateral and multilateral investment treaties do not contain provisions that allow counterclaims from host States, with few exceptions. Hence, claimants usually have nothing to lose other than their own fees and costs. Nevertheless, in some awards the Tribunal has ordered allocation of costs against the claimant. Due to this possible scenario, it has been alleged that claimants using TPF will avoid payment of allocation of costs even if ordered by the tribunal. Notwithstanding, there is no reason to assert that a claim financed by a third-party funder has more risk than any other claim. On the contrary, as explained above, TPF allows an additional risk analysis and has already agreed with its claimant-client how these costs will be covered.
The possibility of a claimant not being able or willing to pay costs is the same whether or not TPF is involved. Either way, there are many ways to ensure payment of costs of litigation (insurance and deposits, among others). The tribunals have absolute freedom to order a security deposit or to accept bank guarantees to satisfy this requirement, even with the current regulation. Therefore, this is not a problem created by third-party funding and nor will it end with its regulation, rather it is an existing issue that is currently well-addressed by tribunals.
Elimination or regulation?
One of the most frequent arguments used by those who oppose TPF in investment arbitration is that since it provides claimants access to funds, more claims will arise. However, as established above, this argument is based on an incorrect premise. All foreign investors that have been harmed by a host State and are protected under a bilateral or multilateral investment treaty or contract clause, have a right to file a claim. “Funding is beneficial and should be supported as it promotes access to justice.” [7] Financial solvency has never meant to be an entry barrier in Investor-State Dispute Settlement. Therefore, if TPF is causing more claims in the system, it is precisely because they are satisfying the existing demand in an economically efficient way. Eliminating the possibility of a claimant to pursue a claim by financing its cost with TPF is a form of denial of justice.
Additionally, “[t]he use of funding offers the client the ability to minimize risk, does not have any negative effect on their cash flow, and ensures payment of lawyers.” [8] This is why third-party funders now not only finance claimants who do not have the funds to litigate [9] but also claimants that seek greater sophistication in their defense by, for example, hiring more experienced or specialized attorneys, hiring more reputable experts, claimants who due to their financial planning choose not to invest their own equity in litigation, [10] among others.
Many of the concerns surrounding TPF are not reflected as a problem in practice. Alternatively, in the few instances that a concern does pose a problem, the system has been able to self-regulate to solve it. The type of regulation that is needed is the recognition of a real situation and financial relationship that occurs frequently in investment arbitration, instead of regulation to control and/or restrict TPF. With its legal recognition, any issue that may occur during an investment arbitration can be treated more clearly, giving predictability to a system in which precisely predictability is not its biggest virtue.
The first step towards regulation is disclosure. Based on the parties’ disclosure, the process continues as set forth in the applicable rules, including the disclosures of the arbitrators concerning any connection they may have to the funder. [11] This would also make it easier for the arbitration institution to retain certain control over potential issues in the relationship with the funder. [12]
It is important to distinguish between the disclosure of the existence of a TPF, and the terms of the agreement between them. [13] Including the terms of the agreement as part of disclosure would imply divulging the third-party funder’s risk and success probability analysis and other sensitive information, such as the terms for a potential settlement, the maximum duration of the process, and other provisions that must be kept confidential between the claimant and the funder.
Third-party funding in investment arbitration is a reality. It is present in a great number of cases and its use is rapidly increasing. Forbidding it even though it enhances access to arbitration is against the notions of efficiency in dispute resolution and fair treatment for the parties.
ENDNOTES
[1] “A second structural issue is that arbitrators, who are paid per case/hour rather than based on a set salary, may be incentivized to not close doors to certain claims or arguments, and instead give the impression that almost every claim is a colorable, non-frivolous one.” See Brook Guven and Lise Johnson. ‘The Policy Implications of Third-party Funding in Investor-State Dispute Settlement’ [2019] CCSI Working Paper 2019, 22.
[2] “Funders say there are still more cases seeking funding than funders looking for litigation to support. Dunn estimates that Harbour Capital receives about 40 applications every month for funds, but commits money to only a handful of these.” Joanne Harris ‘Third-party Time London’ (2012)<https://search-proquest-com.proxygt-law.wrlc.org/docview/1037738574/A6DDD2CACC5A4939PQ/1?accountid=36339> accessed Dec. 14, 2019.
[3] Section 2 b) and c) IBA Guidelines on Conflicts of Interest in International Arbitration, adopted by the IBA Council on October 23, 2014 and updated on August 10, 2015.
[4] UNCITRAL Working Group III, ‘Thirty-seventh session’ (2019), A/CN.9/WG.III/WP.157, 18.
[5] Vicki Waye, ‘Conflicts of Interests Between Claimholders, Lawyers and Litigation Entrepreneurs’, [2007] 19 BOND L. <https://doaj.org/article/dfb6beda06f7416e9629c43ba9a68105> accessed Dec 17, 2019.
[6] ibid.
[7] Munir Maniruzzaman, ‘Third-Party Funding in International Arbitration: A Menace or Panacea?’ (Kluwer Arbitration Blog, 2012) <http://kluwerarbitrationblog.com/blog/2012/12/29/thirdparty-funding-in-international-arbitration-a-menace-or-panacea/ > accessed Dec. 19, 2019.
[8] Nicholas Rowles-Davies, Third Party Litigation Funding (Oxford University Press ed., 2014) 62.
[9] Litigation in general, whether judicial, arbitral; national or international.
[10] “[Dispute Funding] has developed quickly because it allows corporations to unlock the often substantial value they have tied up in unresolved claims, and it allows them to proceed with arbitrations while retaining control of their exposure to loss” C. P. Bogart ‘Third Party Financing of International Arbitration. The European Arbitration Review’ [2017] GAR Special Report 2016.
[11] : “The Working Group may wish to consider, whether third-party funding would have to be disclosed to the tribunal only or also to the other disputing party. While disclosure to the other disputing party may not be necessary in order for the tribunal to identify potential conflicts of interest, the other party may claim the right to comment on a potential conflict of interest. Further, the Working Group may wish to consider if a broad disclosure requirement is desirable against the background of the transparency sought in third-party funding.” UNCITRAL Working Group III, ‘Thirty-seventh session’ (2019), A/CN.9/WG.III/WP. 157, 30.
[12] Arbitration and Mediation Legislation (Third-Party funding) (Amendment) Ordinance 2017, Hong Kong Special Administrative Region, Section 98T (1)(a)-(b); Civil Law (Amendment) Act 2017, Singapore, Section 5(b)(2).
[13] “The question of whether disclosure should be limited to the existence and identity of the funder or whether it should also extend to the terms of the funding agreement remains controversial.” UNCITRAL Working Group III, ‘Thirty-seventh session’ (2019), A/CN.9/WG.III/WP. 157, 21.
Andres Alvarez Calderon Campos, Peruvian litigation and arbitration attorney, with an LLM in International Arbitration & Dispute Resolution from the Georgetown University Law Center.
The views and opinions expressed in the article are those of the author(s) solely and do not reflect the of official position of the institution(s) with which the author(s) is /are affiliated. Further, the statements of the author(s) produced herein should not be construed as legal advice.
