Necessity is the mother of invention. The introduction of third-party funding (‘TPF’) in international arbitration creates a necessary opportunity for a party, whether in financial distress or otherwise, to pursue its meritorious claims against a much more powerful and resourceful opponent. TPF is an increasing reality in the evolving world of high-priced international arbitrations. Since 2012 the market for arbitration funding has grown by well over 500 percent.
TPF establishes relationships whereby a funder finances, partly or fully, one of the parties’ arbitration costs. In cases where claimants are being funded and there is a favourable award, the funder is generally remunerated by a previously agreed percentage of the proceeds. In case of an unfavourable award, the funder’s investment is lost. If a respondent is funded, then the funder contracts to receive a predetermined payment from the respondent, similar to an insurance premium. This agreement may include an extra payment to the funder if the respondent wins the case. The discussion in this article is limited to the scenario in which the claimant procures the funding.
TPF appears in a multiplicity of forms, such as contingency fees, debt instruments, or a full transfer of underlying claims. The basic definition is found in the International Bar Association Guidelines on Conflicts of Interest in International Arbitration (the ‘IBA Guidelines’), where TPF refers to “any person or entity that is contributing funds, or other material support, to the prosecution or defence of the case and that has a direct economic interest in, or a duty to indemnify a party for, the award to be rendered in the arbitration.”
How it works
Large-scale arbitration funders typically start the process of selecting potential claims to be funded by considering a range of factors associated with potential risks of losing the case. Such due diligence may often focus on the jurisdictional hurdles, the merits of the dispute, the prospects of success and enforcement of the arbitral award, the amount of potential compensation, and the expertise of the legal team representing a funded party. Once the funder has decided to finance a claimant, they sign a funding agreement setting out, inter alia, the funder’s level of control over the arbitral strategy, its fraction of the proceeds if the claimant succeeds, and disclosure restrictions.
What are the benefits of engaging TPF in arbitration?
In some instances, external financing of claims is the only way for a claimant to obtain vindication. Claimants who are impecunious or unable to bear the financial risk of arbitration often benefit from TPF. Claimants may have other considerations for utilizing TPF, such as a willingness to maintain cash-flow and offset the risk of an uncertain arbitration outcome. The presence of TPF backing the claim enhances the claimant’s ability to sustain a protracted legal battle, thereby minimizing the threat of dilatory tactics aimed at exhausting the financial resources of the claimant. During the settlement discussions, the claimant would gain more leverage by showing the funder’s confidence in the claimant’s meritorious claim and claimant’s ability to sustain a long trial. Moreover, professional funders provide strategic advice, necessary expertise, and experience to which the claimant would not usually have access.
TPF’s other side of the coin
While external funding helps to level the playing field for an impecunious party by granting access to justice, it may create more imbalances than it eliminates. For example, detractors of TPF question the benefits of external funding, arguing that it creates conflicts of interest, fuels a rise in frivolous and vexatious claims, shifts control over the claim, and forces claimants to sign unfair funding contracts.
First, TPF contracts typically include a confidentiality clause that restricts disclosure of the contract. As the number of professional funders active on the market of international arbitration is limited, the introduction of TPF into the proceedings may impede the impartiality and independence of the tribunal, creating potential conflicts of interest for arbitrators and endangering the legitimacy of the proceedings. A way of resolving this issue might be to impose an obligation on a funded party to disclose the presence of TPF to the tribunal, without going into the details of the agreement, at an early stage of the proceedings. The ordered disclosure would help to assess and eliminate any potential conflicts of interest at the early stage of the proceedings and thus prevent any potential challenges to arbitrators. The IBA Guidelines have taken the first steps in requiring upfront disclosure of TPF and providing that a funder shall be considered the ‘equivalent of the party’ for conflict check purposes. However, main arbitration rules (except the 2017 Singapore International Arbitration Centre Investment Arbitration Rules) have not expressly addressed the issue of mandatory disclosure yet.
Second, TPF may simply mean an increase in claims – both, meritorious and frivolous – that affects respondents. TPF may open the floodgates for frivolous claims and may expose the respondent to a ‘hit-and-run arbitration,’ when the defeated claimant and a funder both fail to pay a costs award. Although the advocates of TPF argue that professional funders rigorously filter meritless cases to maximize the funders’ chances to return their investments, the reality may be different. Professional funders appear to curtail the risks of losses by spreading that risk over many cases. A funder may be keen to take a bigger risk by financing a frivolous claim if it promises a higher return rate or can maximize the value of the funder’s portfolio. In addition, motivated by a pure incentive to maximize a financial gain, a funder may try to force a claimant to inflate its claims beyond their actual value.
The tribunal, however, could mitigate the risk of frivolous claims and ‘hit-and-run arbitration’ by ordering a funded party to place a security for costs in appropriate circumstances. Typically, tribunals order the successful party to recover its costs from the losing party. Under prevailing standards, a tribunal may order security for costs if a party shows that (i) it has a prima facie case of succeeding on the merits; and (ii) the other party has no financial means and thus is unlikely to satisfy a future adverse costs award. The presence of TPF backing the claim may be a relevant factor in the tribunal’s analysis, and thus should be disclosed. Once TPF has been disclosed, the tribunal would be able to assess whether there are sufficient grounds for ordering the security for costs.
Third, there is a concern about shifting control over the claim. As a funder always retains the power of the purse, it can refuse further financing if the claimant does not follow the strategy proposed by the funder. By controlling future payments, the funder can influence various aspects of claim management (e.g. by refusing to settle a claim). However, the claimant’s lawyers should generally act in their client’s best interest according to the rules of professional conduct. These rules (which can also be set out in the funding agreement) may prevent the funders’ attempt to influence the lawyers’ professional advice.
Finally, a funder may use its stronger bargaining power to force the claimant to sign an unfair contract that could entitle the funder to more than 50% of the proceeds of the award. Such risk could be minimized if the claimant seeks professional advice on the terms of the funding agreement, and in parallel negotiates with several competing funders to choose the best deal on the market.
While the presence of TPF remains beneficial in levelling the playing field by offering claimants the financial support to pursue their claims, it may also create imbalances which need to be tackled. With the upfront disclosure of the funder’s involvement and the careful use of security for costs to protect the respondent’s interests, many potential risks and pitfalls can be minimized or even avoided.