Third-Party Financing of Litigation: Legal Approaches and a Formal Model

Abstract

In the article, we discuss the phenomenon of third-party financing of lawsuits, which has been subject to intense debate from a legal as well as from an economic point of view. Drawing on the examples of Germany, Australia, and the United States, we show in Part I that different legal systems still take different approaches to third-party financing and its economic implications. In Part II, we introduce a stylized model that abstracts from the peculiarities of specific legal systems and in which we compare third-party financing of lawsuits with incentive fees for lawyers. We conclude that a combination of contingency fees and third-party financing may be the best way to overcome agency problems and financial constraints of would-be plaintiffs who would like to pursue meritorious claims.

Keywords: litigation, hidden information, hidden action

JEL Classification: K41