Litigation Finance Tax Closes Loopholes for Exploiting Investors

Litigation funders unabashedly paint themselves as altruistic operatives. They characterize their sole purpose as dispensing money—with no strings attached—to help under-resourced individuals file lawsuits to resolve their grievances. But that snapshot reflects some substantial photoshopping.

Third-party litigation funding is actually a secretive industry run by hedge funds, foreign-based financiers, and other entities that invest in litigation in exchange for big paydays at the expense of plaintiffs, US businesses, and our judicial system.

No one knows how big this industry is because it operates in secret and fights anyone who wants to get even a small, commonsense peek behind the curtain.

Available data suggests that funders now manage more than $16 billion in capital, with Hays Mews Capital predicting growth to more than $25 billion by 2030. The returns on those investments are reportedly off the charts, with academic research finding they’ve averaged more than 20% annually, largely unrivaled by other investment opportunities.

Litigation funders don’t achieve such profits through charitable behavior. Notwithstanding non-stop declarations that they don’t run the lawsuits they support, funders frequently do exercise control by steering cases to maximize their profits, to the detriment of the plaintiffs they purport to be “helping.”

Several years ago, the contract through which Sysco Corporation received financing to initiate antitrust class actions gave the funder veto power over proposed settlements. Invoking those provisions, the funder made Sysco forgo settlements it desired and turn over its claims to the funder.

Litigation funding is warping the US judicial system. Funders sometimes invest heavily in dubious claims and in recruiting individuals to file such claims, hoping defendants (including small businesses) can be pressured to pay huge settlements to escape the burdens of litigating.

More than a decade ago, a major funder invested in Ecuadorian environmental litigation in exchange for a percentage of the outcome. The Ecuador trial court awarded $18 billion against the US-based defendant, and counsel charged in to enforce that judgment. The US court rejected that effort, finding “ample evidence” that the award was obtained fraudulently.

There also are national security risks with litigation funding, as foreign-based entities have become increasingly active in US litigation funding. China-based Purplevine has financed US intellectual property lawsuits. And wealthy Russian oligarchs have poured money into financing US lawsuits in schemes to avoid international sanctions.

As US Department of Justice Foreign Agents Registration Act enforcement personnel have warned, foreign-based entities may threaten our national security by using litigation funding to sue US businesses to drain their resources and access their trade secrets through discovery.

Despite all of this, the litigation funding industry can take advantage of a tax loophole. Under present US tax law, foreign-based litigation funders typically aren’t required to pay any US taxes on income from their litigation funding, while US-based funders pay only capital gain rates (23.8%). Yet, plaintiffs must pay ordinary income rates (up to 37%) on any recovery they receive.

In other words, litigation funders have a major tax break that isn’t available to the plaintiffs they claim they want to help get justice.

Fortunately, lawmakers have started to take notice. A key proposal in the One Big Beautiful Bill from Sen. Thom Tillis (R-N.C.) and Rep. Kevin Hern (R-Okla.) would close this loophole.

Because plaintiffs are taxed at ordinary income rates, it would require all litigation funders to pay the top ordinary tax rate on their earnings, as well as an additional 3.8%, which aligns with the net investment income tax that is applied to passive income for higher-income taxpayers.

Predictably, the litigation funders are pulling out all the stops to claim this proposal would drive them out of business. The reality is that the Tillis-Hern proposal is a simple, commonsense reform that would require litigation funders to bear the same tax burden as plaintiffs and make clear that the tax code shouldn’t subsidize spurious litigation.

Despite how the industry seeks to portray itself, litigation funding isn’t about access to justice. Litigation funding is about getting paid first, with as much money taken from the plaintiffs’ recovery as possible. Unless we act now, our legal system will turn into a place where justice is about the most financial gain for funders, rather than justice for everyone.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Stephen Waguespack is the president of the U.S. Chamber of Commerce’s Institute for Legal Reform

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